Recently in Federal Reserve 2008 Category

So the FOMC had a meeting today.  Of course with rates already at 0-25 basis points, it just doesn't generate the same level of excitement.  Still, the discussions in the meeting are no less important.  In that spirit, here is the text of the press release.

The Federal Open Market Committee decided today to keep its target range for the federal funds rate at 0 to 1/4 percent. The Committee continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.

Information received since the Committee met in December suggests that the economy has weakened further. Industrial production, housing starts, and employment have continued to decline steeply, as consumers and businesses have cut back spending. Furthermore, global demand appears to be slowing significantly. Conditions in some financial markets have improved, in part reflecting government efforts to provide liquidity and strengthen financial institutions; nevertheless, credit conditions for households and firms remain extremely tight. The Committee anticipates that a gradual recovery in economic activity will begin later this year, but the downside risks to that outlook are significant.

In light of the declines in the prices of energy and other commodities in recent months and the prospects for considerable economic slack, the Committee expects that inflation pressures will remain subdued in coming quarters. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.

The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. The focus of the Committee's policy is to support the functioning of financial markets and stimulate the economy through open market operations and other measures that are likely to keep the size of the Federal Reserve's balance sheet at a high level. The Federal Reserve continues to purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand the quantity of such purchases and the duration of the purchase program as conditions warrant. The Committee also is prepared to purchase longer-term Treasury securities if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets. The Federal Reserve will be implementing the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. The Committee will continue to monitor carefully the size and composition of the Federal Reserve's balance sheet in light of evolving financial market developments and to assess whether expansions of or modifications to lending facilities would serve to further support credit markets and economic activity and help to preserve price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Dennis P. Lockhart; Kevin M. Warsh; and Janet L. Yellen.  Voting against was Jeffrey M. Lacker, who preferred to expand the monetary base at this time by purchasing U.S. Treasury securities rather than through targeted credit programs.

I find it interesting that one member, Mr. Lacker, preferred purchasing U.S. Treasury securities.  Recall that at the last meeting, it was reported in the press release that the Fed would be evaluating the benefits of such an action.

Reuters is reporting that President-elect Obama will nominate Georgetown law professor Daniel Tarullo for one of the two open seats on the Federal Reserve Board of Governors.  Story here.  Tarullo's bio here.

From the looks of his qualifications, Tarullo will add some expertise to the Board in the area of financial regulation.  Having a legal scholar on the Board will be quite beneficial for the Fed as it copes with changing regulations, both those that they write and those that affect the environment in which they operate.

... to have a zero funds rate.  Well, almost zero.  When I got up this morning to give my final exams, I thought how the FOMC will almost certainly go down to 25 b.p.  They'll want to go all the way to zero, but something in them just doesn't want to say "zero".  They need a way to go to zero without really saying that they're going to zero.

And so they did.  (FOMC Statement)

The Federal Open Market Committee decided today to establish a target range for the federal funds rate of 0 to 1/4 percent. 

Since the Committee's last meeting, labor market conditions have deteriorated, and the available data indicate that consumer spending, business investment, and industrial production have declined.  Financial markets remain quite strained and credit conditions tight.  Overall, the outlook for economic activity has weakened further.

Meanwhile, inflationary pressures have diminished appreciably.  In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate further in coming quarters.

The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability.  In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time. 

The focus of the Committee's policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level.  As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant.  The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities.  Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses.  The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity.

It had to be done.  If we were to go another 6 weeks speculating about whether and when we would actually have quantitative easing, I'm not sure the market could cope with the uncertainty.  To go down to 25 b.p. is effectively an admission that they need to go to zero, so you might as well just do it.

Now the game has changed.  Say what you will about the fact that the normal monetary policy channels haven't been working for some time.  That is history now.  Tomorrow when they get up and go to work, they will have to come to terms with the fact that they have committed to operating in a whole new environment.  December 16, 2008 will be right up there with October 6, 1979 in the short list of monetary turning points--but the turn is in the opposite direction.

Tomorrow their real work begins--revealing to the world what it means to "employ all available tools".  That phrase is going to be ringing in my head all night.

Full text of speech at the Fed's website.

Here's the money quote:

Regarding interest rate policy, although further reductions from the current federal funds rate target of 1 percent are certainly feasible, at this point the scope for using conventional interest rate policies to support the economy is obviously limited. Indeed, the actual federal funds rate has been trading consistently below the Committee's 1 percent target in recent weeks, reflecting the large quantity of reserves that our lending activities have put into the system. In principle, our ability to pay interest on excess reserves at a rate equal to the funds rate target, as we have been doing, should keep the actual rate near the target, because banks should have no incentive to lend overnight funds at a rate lower than what they can receive from the Federal Reserve. In practice, however, several factors have served to depress the market rate below the target. One such factor is the presence in the market of large suppliers of funds, notably the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, which are not eligible to receive interest on reserves and are thus willing to lend overnight federal funds at rates below the target. We will continue to explore ways to keep the effective federal funds rate closer to the target.

Although conventional interest rate policy is constrained by the fact that nominal interest rates cannot fall below zero, the second arrow in the Federal Reserve's quiver--the provision of liquidity--remains effective. Indeed, there are several means by which the Fed could influence financial conditions through the use of its balance sheet, beyond expanding our lending to financial institutions. First, the Fed could purchase longer-term Treasury or agency securities on the open market in substantial quantities. This approach might influence the yields on these securities, thus helping to spur aggregate demand. Indeed, last week the Fed announced plans to purchase up to $100 billion in GSE debt and up to $500 billion in GSE mortgage-backed securities over the next few quarters. It is encouraging that the announcement of that action was met by a fall in mortgage interest rates.

Translation:  They're not done yet.

T.S. Eliot wrote that April is the cruelest month.  In the academic year, November shares some similarities with April in that it's when we start to come to grips with the fact that this semester will end... and soon.  For me, blogging seems to take a hit in November.  I'd tell you what's been keeping me busy, but it really is academic minutiae.  You'd be bored to tears.

November has been a cruel month for the markets as well, especially the last couple days.  Some days I turn on CNBC and literally see things that I never thought I'd see.  Watching the 30 year Treasury yield take a dive like it did yesterday would be one of those things.  Seeing Citi at less than $4 would be another.  Hearing perfectly reasonable people fret about the possibility of deflation would be still another.

How do you title a blog post these days without sounding like a doom-and-gloomer?  I feel like I want to choose my words very carefully to avoid making things seem worse than they are.  (I know how you feel, King!)  But when you hear speculations of a pretty sizeable drop in GDP in the 4th quarter and graphs showing this to be the worst stock market decline since the Great Depression, it's easy to get caught up in it.

So as I work my way back into the swing of things over this Thanksgiving break, let's just set the stage.

The auto bailout:  Not a good idea, but probably going to happen in some way, shape, or form.  At the rate that they're burning cash, I don't see what a bailout would reasonably hope to accomplish.  A fast track to a government assisted bankruptcy would probably be better in the long run.  I would support proposals to protect the pensions of workers, especially those near retirement because that represents a past promise that people took into account when making decisions. That's probably a good topic for a future post.  But this decline has been a long time coming, and trying to stop it is just going to add to the problems later.

Paulson's reversal:  I, for one, found that episode at least somewhat refreshing.  Some say that he realized that $700 billion would not be nearly enough.  Perhaps.  But if that's the case, I'd rather he stopped at the brink of the canyon like he did rather than jumping in and then telling us.  Yes, we could use some more transparency in seeing where the money has gone so far.  But most importantly, the fact that they're holding back some of that money means that at least one agency is doing something to keep its powder dry.  Which brings us to...

What will the Fed do in December?   That's what my macro classes are working on figuring out.  After Thanksgiving, I'll be discussing Poole's 1970 QJE paper with my grad students.  I guess that will be as good a time as any to bring up this development: (Bloomberg)

``There has been a policy shift, but the Fed is not transparently announcing what it is doing and why,'' said former St. Louis Fed President William Poole, now a senior fellow at Cato. ``Monetary policy works best when the markets understand what the central bank is doing.''

Some analysts point to the surplus cash that banks keep on deposit at the Fed as a key gauge of the Fed's monetary-policy stance. The so-called excess reserves have ballooned to $363.6 billion from $2 billion in August as the Fed added to its emergency lending programs.

``It is a move to quantitative easing, to force lots and lots of reserves into the banking system with the expectation that banks will start to trade them for a higher-yielding asset,'' said Poole, a Bloomberg contributor, said yesterday in a Bloomberg Television interview.

Hat tip to Calculated Risk.

Indeed, when you see things like this, it makes you wonder what is going on.  I'm going to be thinking about that a lot this week during the break from classes.

So what about deflation?  I'm not in the camp that thinks it's a big problem yet.  It becomes a real problem if wage declines make it even more difficult for people to make their mortgage payments or if price declines are so widespread and expected that people hold off spending now as they expect prices to go down further.  I don't see us getting there yet, but I stand ready to revise my expectations as new data arrives.

And finally stock market:  I'm just as caught up in it as you are.  My explanations are no better than anyone else's.  It does appear that we're on the verge of something with Citi, and people are getting worried about commercial real estate.  Those make for some strong headwinds. 

As I go around town I hear comments both positive and negative.  Everyone complains about their 401(k)s, but local businesses are hiring.  I do think that we're in a recession as we would define one nationally.  However, the impact is going to be very different for various regions and economic sectors.  It's difficult to fight recessions like this because it becomes more tempting to try to target policies at one area or another, and that's not always good or successful.

But it does give us things to talk about.

FOMC press release:

The Federal Open Market Committee decided today to lower its target for the federal funds rate 50 basis points to 1 percent.

The pace of economic activity appears to have slowed markedly, owing importantly to a decline in consumer expenditures. Business equipment spending and industrial production have weakened in recent months, and slowing economic activity in many foreign economies is damping the prospects for U.S. exports. Moreover, the intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit.

In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate in coming quarters to levels consistent with price stability.

Recent policy actions, including today's rate reduction, coordinated interest rate cuts by central banks, extraordinary liquidity measures, and official steps to strengthen financial systems, should help over time to improve credit conditions and promote a return to moderate economic growth. Nevertheless, downside risks to growth remain. The Committee will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Elizabeth A. Duke; Richard W. Fisher; Donald L. Kohn; Randall S. Kroszner; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh.

In a related action, the Board of Governors unanimously approved a 50-basis-point decrease in the discount rate to 1-1/4 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, Cleveland, and San Francisco.

There are some new features in the exact wording, such as "the Committee expects inflation to moderate in coming quarters to levels consistent with price stability".  Seems like only six weeks ago that they expected "inflation to moderate later this year and next year, but the inflation outlook remains highly uncertain."

Greg Mankiw has a good idea on how to recapitalize the ailing financial sector.  Read the whole thing.

Readers wondering about why coordination among central bankers matters (as in today's coordinated rate cut) may benefit from this old post from 2006.  The subject is a NY Times piece by Hal Varian.

Since this is such an unusual event, I'm just going to print the entire press release complete with links to other central banks.

Joint Statement by Central Banks

Throughout the current financial crisis, central banks have engaged in continuous close consultation and have cooperated in unprecedented joint actions such as the provision of liquidity to reduce strains in financial markets.

Inflationary pressures have started to moderate in a number of countries, partly reflecting a marked decline in energy and other commodity prices. Inflation expectations are diminishing and remain anchored to price stability. The recent intensification of the financial crisis has augmented the downside risks to growth and thus has diminished further the upside risks to price stability. 

Some easing of global monetary conditions is therefore warranted. Accordingly, the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, Sveriges Riksbank, and the Swiss National Bank are today announcing reductions in policy interest rates. The Bank of Japan expresses its strong support of these policy actions.

Federal Reserve Actions
The Federal Open Market Committee has decided to lower its target for the federal funds rate 50 basis points to 1-1/2 percent. The Committee took this action in light of evidence pointing to a weakening of economic activity and a reduction in inflationary pressures. 

Incoming economic data suggest that the pace of economic activity has slowed markedly in recent months. Moreover, the intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit. Inflation has been high, but the Committee believes that the decline in energy and other commodity prices and the weaker prospects for economic activity have reduced the upside risks to inflation. 

The Committee will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability. 

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Elizabeth A. Duke; Richard W. Fisher; Donald L. Kohn; Randall S. Kroszner; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh. 

In a related action, the Board of Governors unanimously approved a 50-basis-point decrease in the discount rate to 1-3/4 percent.  In taking this action, the Board approved the request submitted by the Board of Directors of the Federal Reserve Bank of Boston.

Information on Actions Taken by Other Central Banks
Information on the actions that will be taken by other central banks is available at the following websites:

Bank of Canada
Bank of England
European Central Bank
Sveriges Riksbank (Bank of Sweden)
Swiss National Bank (51 KB PDF) 

Statements by Other Central Banks
Bank of Japan (65 KB PDF)

David Altig takes up the question with links back to Marginal Revolution, DeLong, as well as my post from yesterday.  (Thanks, David!)

Rather than looking at it as what DeLong calls "Operation Twist", Altig opts for the simpler explanation that it will put a lower bound on the effective fed funds rate.  That is, of course, the fundamental effect that this would have in any circumstance--crisis or not.  It puts the Fed in as the residual buyer of the funds and thus establishes the floor.

The apparent lack of a (non-zero) lower bound on the funds rate was first noticed over a year ago when there were trades happening at zero percent.  Here's what I said in August 2007:

So while I don't have a full and definitive explanation [for the zero percent transactions], it would seem that borrower risk is a factor, and the fact that these are excess reserves (which earn no interest) is also a factor. In that case, the low end of the range could stay low until the reserve picture gets back to normal.

When the Fed began discussing it more seriously in May 2008, I said:

I'll go on the record that this is a good idea. It will help to smooth out the recent fluctuations in the funds rate that garnered so much consternation at this blog among other places. It would prevent interest rate policy from getting in the way of policies for directly injecting liquidity into the financial markets by effectively keeping a floor on the funds rate even during a big injection of liquidity.

So I am clearly on board with the stated reasoning behind the move.  Plus, I think it's just a good policy to eliminate what is effectively a tax on reserves.

But I was struck by DeLong's comment about open market operations on the risk premium rather than on the liquidity premium.  The more this drags on and the more we learn, the more I am coming to the conclusion (see here, for example) that this is a problem with the risk premium.  Why else would the CP market freeze up despite the massive injections of liquidity, not to mention the CDS market?  There seems to be a lot of liquidity out there, but it's not necessarily getting to where it needs to go.

And that got me wondering if paying interest on reserves might, as Tabarrok suggested, accomplish the goal of getting that liquidity where it needs to go in an Operation Twist sort of way.  While the Fed is not yet targeting particular assets, we're treading very close to the kind of environment where that might be necessary.  (Have you seen a T-bill rate lately?)  Having the ability to pay interest on reserves would not be counter to that purpose, even if it wasn't the primary reason.  Of course, it should also be noted that the paying of interest on reserves is a permanent change rather than a temporary one meant only for the crisis.

Paying interest on reserves is a good policy for a lot of reasons.  The obvious ones and the ones that might still be a stretch--at least for now.

Press Release from the Fed:

The Federal Reserve Board on Tuesday announced the creation of the Commercial Paper Funding Facility (CPFF), a facility that will complement the Federal Reserve's existing credit facilities to help provide liquidity to term funding markets. The CPFF will provide a liquidity backstop to U.S. issuers of commercial paper through a special purpose vehicle (SPV) that will purchase three-month unsecured and asset-backed commercial paper directly from eligible issuers. The Federal Reserve will provide financing to the SPV under the CPFF and will be secured by all of the assets of the SPV and, in the case of commercial paper that is not asset-backed commercial paper, by the retention of up-front fees paid by the issuers or by other forms of security acceptable to the Federal Reserve in consultation with market participants. The Treasury believes this facility is necessary to prevent substantial disruptions to the financial markets and the economy and will make a special deposit at the Federal Reserve Bank of New York in support of this facility.

The commercial paper market has been under considerable strain in recent weeks as money market mutual funds and other investors, themselves often facing liquidity pressures, have become increasingly reluctant to purchase commercial paper, especially at longer-dated maturities. As a result, the volume of outstanding commercial paper has shrunk, interest rates on longer-term commercial paper have increased significantly, and an increasingly high percentage of outstanding paper must now be refinanced each day. A large share of outstanding commercial paper is issued or sponsored by financial intermediaries, and their difficulties placing commercial paper have made it more difficult for those intermediaries to play their vital role in meeting the credit needs of businesses and households.

By eliminating much of the risk that eligible issuers will not be able to repay investors by rolling over their maturing commercial paper obligations, this facility should encourage investors to once again engage in term lending in the commercial paper market. Added investor demand should lower commercial paper rates from their current elevated levels and foster issuance of longer-term commercial paper. An improved commercial paper market will enhance the ability of financial intermediaries to accommodate the credit needs of businesses and households.

This will bring a sigh of relief to the commercial paper market. Think of it this way.  The Fed is betting that there are a lot of mutually beneficial trades out there that are not happening because the participants either afraid that they will not get paid back or that they will not be able to liquidate the paper they hold if they need quick cash.  In normal times this action would not be necessary.  But these are not normal times.  John Jansen at Across the Curve has been reporting on the CP market for a while, and if what he's been saying is true then this was a very smart and very necessary move.

So says Reuters (and CNBC)

The statement came after U.S. business television channel CNBC reported the Fed was planning talks with the Chicago Mercantile Exchange, or CME, and the Intercontinental Exchange, or ICE, on the creation of a CDS exchange. The companies declined to confirm the report, although they said they would be willing to participate in any initiative.

And Calculated Risk says:

Apparently CNBC's Steve Leisman reported (I didn't see it) that the Fed might announce tomorrow morning some sort of program to buy commercial paper.

I had CNBC on in the background tonight and I think I heard that as well.  John Jansen says he has heard something to that effect from three sources.  And if you haven't been reading his blog lately, you're not fully informed.  From what I'm reading at his blog and other sources, it appears that the levels of risk aversion out there are just incredible.  Institutions are not lending because they have no way to assess the creditworthiness of their counterparties.  As a result, good trades are being passed over.  This cannot go on for very long without causing some significant problems. 

As I've said before, it's an information problem (which has led to a problem of risk assessment).  We are in need of transparency, pure and simple.  Unfortunately, getting it will not be that simple.

From the Federal Reserve:

The Financial Services Regulatory Relief Act of 2006 originally authorized the Federal Reserve to begin paying interest on balances held by or on behalf of depository institutions beginning October 1, 2011. The recently enacted Emergency Economic Stabilization Act of 2008 accelerated the effective date to October 1, 2008. 

Employing the accelerated authority, the Board has approved a rule to amend its Regulation D (Reserve Requirements of Depository Institutions) to direct the Federal Reserve Banks to pay interest on required reserve balances (that is, balances held to satisfy depository institutions' reserve requirements) and on excess balances (balances held in excess of required reserve balances and clearing balances). 

The interest rate paid on required reserve balances will be the average targeted federal funds rate established by the Federal Open Market Committee over each reserve maintenance period less 10 basis points. Paying interest on required reserve balances should essentially eliminate the opportunity cost of holding required reserves, promoting efficiency in the banking sector. 

The rate paid on excess balances will be set initially as the lowest targeted federal funds rate for each reserve maintenance period less 75 basis points. Paying interest on excess balances should help to establish a lower bound on the federal funds rate. The formula for the interest rate on excess balances may be adjusted subsequently in light of experience and evolving market conditions. The payment of interest on excess reserves will permit the Federal Reserve to expand its balance sheet as necessary to provide the liquidity necessary to support financial stability while implementing the monetary policy that is appropriate in light of the System's macroeconomic objectives of maximum employment and price stability.

Tyler Cowen thinks it is what Brad DeLong suggested as "Operation Twist on a Pan-Galactic scale."  I agree.  The effect will be small, but it probably won't hurt.

Alex Tabarrok at Marginal Revolution writes:

The consensus among economists is now clear, the best strategy for dealing with the financial crisis is to recapitalize the banks that need recapitalization.  Paul Krugman, John Cochrane, Luigi Zingales, Douglas Diamond, Raghuram Rajan and many others all advocate some form of recapitalization as do Tyler Cowen and myself.  Krugman would prefer a recapitalization in the form of nationalization.  In my view, there is still plenty of private money to buy banks at the right price and my preferred model is the FDIC leading a speed bankruptcy procedure, as was done brilliantly with Washington Mutual (Cochrane also supports this model.)  In the middle are most of the others who have a variety of good ideas to require the banks to raise equity in various ways.

...

There is also a consensus among economists that the bailout bill is not the right policy.  None of the above economists, for example, is enthusiastic about the bailout.  My bet is that all of us think that the bailout has a substantial likelihood of failing.  The support that exists is born out of hope and fear not judgment and experience.  Nevertheless, the political consensus is that a bailout is what we will get whether it is likely to work or not.  

Count me among those not enthusiastic.  My grudging support is not out of fear, per se--that's too strong a word.  Rather, I am convinced that we're in for a bumpy ride either way, and even a suboptimal plan like this has the potential to make the ride less bumpy.  Furthermore, I think that the moral hazard risks are small in the short term, and there is plenty of time to deal with the long term later.

But what is done is done.  Payrolls fell another 159,000 in September.  The unemployment rate did not rise this month, but it will catch up in time.  And let's be clear once again.  This bailout bill will not prevent a recession.  As James Hamilton says, that's a "done deal".  This bill will not restore calm to the financial markets either.  The best we can hope for out of this bill is that it can help facilitate the revealing of information in the markets sooner than would take place without it.  That might prevent an unnecessarily protracted downturn.

You won't find me celebrating this bill, but I am looking ahead with anticipation to see if it can get counterparties trading with each other again.  If it can do that, it will achieve some measure of success.

It's a familiar phrase to anyone who regularly reads legislation.  Most people would call it "pork."  It's the extra stuff that goes into a bill to make it palatable to legislators who are not totally in favor of the main purpose of the bill.  These items are not necessarily enough to convert a staunch opponent, but enough to get those on the fence to come to your side.  It's a political application of the economist's old friend, "thinking on the margin."

With that as prelude, I offer you this link to the bill passed by the Senate and now before the House.  It is now 442 pages long.  The pork "other purposes," begin on page 110 and continues for the next 330 pages (there are a couple of essentially blank pages at the end).  The math works out nicely to be 75% "other purposes" by volume though not by money.

Ever since this latest and most intense phase of the ongoing crisis began a few weeks ago, I have been convinced of the need for a coordinated approach to unclogging the credit markets.  Efforts to manage the specific incidents (AIG, WaMu, etc.) have been generally pretty good--if pretty good means that there have been no runs on banks and no catastrophic failure of the financial system.  In fact, as I have pointed out in a couple of media interviews lately, the response of the FDIC has been superb.  So far, they have my vote for the "most valuable player" in the handling of the situation.  Because of their experience and efficiency in handling bank failures, I would fully support a measure that would guarantee that FDIC continues to have access to the Treasury to meet its mission.  FDIC was created for just this sort of thing, so let's utilize them.

But there is a limit to what FDIC can do.  The Fed can do a little bit more.  They have the authority to respond to emergencies by lending to entities outside their normal purview.  While there is always a danger that such authority could be used unnecessarily, in my estimation they have acted responsibly thus far.  But even the Fed is limited to the role of responding to emergencies rather than acting entirely proactively.  To act more proactively, that is, to systematically purchase troubled assets in a way that many think needs to be done, requires Congressional authority.  And that's why we're here having this discussion.

There are, however, many reasons to be cautious about granting that authority.  Obviously it requires transparency and oversight.  Provisions that limit golden parachutes and give the taxpayer a chance to share the upside are also unobjectionable to me.  Assessing financial institutions for a portion of the costs is also a good idea.  Handing the Treasury Secretary a blank check would clearly be a very bad idea.

The biggest problem right now is clearly a lack of information (asymmetric information as well, but in some cases it is truly lacking).  It is evident from the TED spread and other data that lending among the major institutions is being constrained by uncertainty over how to assess counterparty risk.  This is not healthy, and it's not going to go away until some more information is revealed.  Any bailout package should be designed with that in mind.  If the Treasury is allowed to take some of the bad assets off of a bank, it may send a signal to counterparties that they are less risky.  This would help to get funds moving again.

And let me just head off anyone who would say that we don't need to "get funds moving again" because that's what got us into that mess.  That's just wrong.  Getting the counterparties creditworthy again will not create an undue amount of moral hazard.  This market has been slammed--big time.  Getting the funds moving in a more normal way will not bring about a return to subprime, interest only, no-doc loans.  At least not for a long time, and in that time we can talk about smart regulation to prevent that from happening again.

In summary, here's what I like about the proposal going through Congress:

• Wall Street shares the cost (see pages 9-12 of the legislation)
• Limits on executive compensation
• Making the $700 billion available in tranches

Things I don't like as much:

• A temporary increase in the $100,000 per account limit on FDIC insurance to $250,000.  Why?  I don't like fiddling with such important institutions on a temporary basis.  That figure is due for an upward adjustment due to inflation (and an increase in the premiums banks pay).  Why not do that and make it permanent?  (UPDATE:  But don't do it during the crisis, see below).
  
• Ability of the Treasury to suspend mark-to-market rules.  Why?  Similar reasoning.  I rarely would favor a temporary change in rules that are meant to foster transparency.  Mark-to-market may be flawed, but I'm afraid that temporarily suspending it right now would only add to the confusion.

Things I just don't like:

• "...and for other purposes"  Why?  You figure it out.  (Look at page 294 for an example.)
  

Is this legislation better than nothing?  All week I've been wanting to be able to say yes, but I am finding it difficult to do so.  There is something to be said for having a plan in place in case we need it in the next three months that Congress is out of session.  And yet, I find myself disappointed in the process and not that crazy about the final product.

There is no doubt in my mind that on balance this legislation is worse than what was voted down on Monday, but this one might actually pass.  That's how Congress works.  This legislation is not something that we urgently need to prevent a depression, and it simply will not prevent whatever recession may be in the works.  If it passes, it might reduce some of the anxiety in the credit market sooner.  If it fails, the Fed will probably be called on to use its emergency lending authority again.  The latter is not optimal, but it is probably workable.

The really sad thing is that the "other purposes" are not really out of the normal realm of business.  While it grates at me, it is part of the legislative game.  But if you think that facilitating price discovery and getting institutions to show their cards well help reduce counterparty risk, then this might be the best plan you'll get.  It's not a solution.  A solution seems very far away at the moment.  But it's probably marginally better than doing nothing and hoping for the best.

And I think I'll just leave it at that.

For today's other commentary, see Arnold Kling (who has had very good material lately) and Tyler Cowen (with whom I am in general agreement).

UPDATE:  King Banaian doesn't like the increase in the FDIC limit either.  He is worried about the moral hazard and that it would lead to banks taking more risks to try to recover their losses (as in what led up to the S&L crisis).  He's right about that.  I still think the temporary aspect of it makes it worse.  Let me be clear.  I think the limit should be increased permanently to adjust for inflation, but it does not need to be done in this bill.  It is not an urgent matter.  And furthermore, if and when the limit is raised, the insurance premiums paid by banks should increase as well.  In the meantime, the present practice of the FDIC in insuring the first $100,000 with certainty and making any decision to insure deposits beyond that on a case-by-case basis is sufficient for now.

...is by David Altig.  (Though some of his commenters have dissenting views.)

Five days ago, I wrote:

So I am fairly confident that a "workable" solution will be reached before the markets open on Monday.  I do not look for an "optimal" solution.  If an optimal solution exists, it is undoubtedly too complicated to be "workable".  But I believe that a number of ideas on the table have the potential to avert a complete meltdown.  I think that when all the parties (including both McCain and Obama) meet behind closed doors and really come to grips with the magnitude of the problem and the fact that a workable solution exists, we'll get one.

I sure hope I'm right.

I was wrong.  At least for now.  There's always the possibility that something will happen later this week.  I don't know what the likelihood is.  Obviously the party whips don't know either--and they're the ones who should. 

At the moment, the way I am organizing my thoughts about the situation is in the form of questions and answers.  So here are the questions I've been asking myself, and my best attempts at some answers.

Q:  Did we need this bill?
A:  I would be careful not to say that we needed this bill.  That is, neither this bill nor any bill was or is a necessary condition for preventing financial Armageddon.  Certainly there were some other options out there other than this bill that I may have preferred.  But after the bill failed, the Federal Reserve announced additional lending measures.  This represents another stop-gap measure that hopefully will help us limp through tomorrow.  The Fed could (with the assistance of special treasury issues) continue to do this for some time.  But of course this is not what we like to see either.  It would be nice to get a legislative solution.  However, if Congress is too dysfunctional to do it, then so be it.  There are other ways.

Q:  What is the biggest mistake that Congress and others are making?
A:  Actually, I see two misconceptions being perpetrated out there.  One is the framing of this issue as Wall Street versus Main Street.  That is, that the government is taking from Joe Six-Pack to give to big bankers.  On the other side of the aisle, there are those who oppose this or any "bailout" out of an unwavering commitment to free market principles.  That is, the bailout is just socialism by another name and should be rejected outright.

Both views have an element of truth, but both views also miss the point.  I think most of my readers understand the connection between Wall Street and Main Street.  However, it is becoming clearer that many people have never made that connection.  And let's be clear, it's not about the stock market!  The fact that the stock market dropped over 700 points is a symptom--not the disease.  The reason to do the deal is not to prop up the stock market--though that certainly gets (and deserves) a lot of attention.  But the drop in the stock market is just an indicator of the drying up of liquidity.  If you doubt this, just read John Jansen's excellent blog (Across the Curve).  If this continues for much longer, it WILL cause firms to have difficulty meeting payroll, paying for inventory, and financing expansion.  At that point, Main Street is affected.  That is what happened in the Great Depression in a very big way.  We may be able to stave off a Great Depression, but there is the potential for a very severe recession.

Those who say the bailout is socialism may say that a severe recession may be the price we have to pay and is not an excuse for such an intervention.  I understand this argument, and it is not entirely without merit.  If the situation, as I understand it to be, was less dire, I might even agree.  But Ben Bernanke is a student of the Great Depression.  If he's worried, then I am too.  My own study of history tells me that this is the closest we have come to such a scenario since the Great Depression.  So I am willing to put aside the "bailout is socialism" argument and argue that a strong government response is warranted.

Let's take a look at some very smart words from Robert Shiller, an economist that I respect a great deal:

So is the government's bailout a major departure? Hardly. Today's federal involvement offers bailouts as a strictly temporary measure to prevent a system-wide financial calamity. This is entirely in keeping with our basic principles -- as long as the bailout promotes, rather than hinders, financial democracy.

Which, so far, it seems to. Congressional critics may be right to demand more help for homeowners and more accountability for Wall Street blunders, but the core idea of the plan is sound: to protect the financial infrastructure. Remember, Fannie Mae used to be a government entity, and by taking it over, the federal government is merely returning to the status quo ante. The measures to take toxic debts off the hands of financial and insurance firms are intended only to deal with a crisis, not to transform our financial system. The proposals do not represent any landmark change in the American way of prosperity. Everyone should take a deep breath. Changing our thinking about finance does not mean abolishing capitalism, but it does raise questions about what the changes mean.

Indeed.  Whatever "bailout" happens, if any, it will not be a permanent intrusion of socialism into the financial markets.  In fact, this represents a tremendous opportunity to modernize the financial system.  By "modernize", I don't mean the kind of derivatives that got us into trouble, but rather a sensible set of regulations that acknowledge the moral hazard problem and prevent institutions from doubling-down on a bad bet.  Read the rest of Shiller's column for more specifics.  I agree with his assessment.

This is a profoundly unique moment in our financial history.  The Fed and the Treasury will do what they can with or without Congress--they have made that clear.  Hopefully that will allow us to limp along.  But I am really starting to worry about the possibility of a stagnant economy for many months if the normal lending channels are not unclogged very soon.

For the last few days, I've been listening/reading rather than talking/writing.  Reflecting on what I have read and heard, there is one thing that stands out.

Everybody's got their own idea of how they would fix the financial markets.

Some are actually pretty good and might even work better than what we'll probably get.  Others sound good but probably wouldn't work in practice.  Others are downright nonsense.

But the purpose of this post is not to list and categorize all of the proposals floating through the blogosphere.  Nor will I offer a complete proposal of my own.  Rather, I just want to offer a few general observations.

I'm generally in favor of getting this toxic paper off of the balance sheets of the banks in the interest of unclogging the system and restoring a sense of normalcy in the markets.  I am genuinely concerned about what could happen if the banks continue to hold this paper for a long period of time.  The crisis of confidence and the inability to lend would lead to a stagnation not unlike Japan in the 1990s.

So if we agree to take this paper off the books of the banks, the next step is to agree on a way of valuing that paper.  Given that the market for this paper is not functioning very well, price discovery is a challenge.  The government would be making the market, and being the only buyer of any consequence, you'd think that they would be able to buy the paper at a pretty good discount.

But...

If the government buys the paper at fire sale prices, you still have the solvency problem and many financial firms could go under.  While many folks may not lose a lot of sleep over this, there still is the matter of making sure that the market participants are on sufficient footing to move forward in the aftermath.  With lots of insolvent firms out there, credit will still be constrained.

Since fire sale prices will not cure the insolvency problem and since paying more than market prices means taxpayers are more likely to lose, there is a reason to look for another way.  It would not be out of line to require troubled institutions to give up some equity in return for the above market price on the assets.  That way, the shareholders will bear some of the cost--as they should.

It is also not out of line to demand management changes and a reduction of the "golden parachutes".  I am not against multi-million dollar salaries for CEOs whose leadership is valued by the market.  But I do believe that some of the cases we have seen recently are evidence of a collective action problem in which the shareholders have been unable to exert the optimal level of control over compensation issues.  In the long run, that's a problem that deserves more study.  In the short run, in the case of insolvent firms dumping their toxic paper, a more direct approach may be in order.

I'm not against having the firms being "bailed out" suffer a little pain in the process.  But for the sake of the system, that pain cannot be so severe that it threatens the ability of the firms to function in the future.  If you're looking for my bottom line, there it is.

There will have to be regulatory changes going forward.  However, it is impractical, and I believe folly, to require those changes as a condition to passing this "bailout" package as some in Congress would like.

The world markets are watching.  At the moment, the world markets are extending their forbearance to us as they wait to see how we are going to handle the solvency crisis that now looms large even as the liquidity crisis enters its end game.  They have been very patient with their forbearance.  But if inaction means a significant risk of catastrophic failure of these institutions, then the world's patience will wear thin.  And that's a scary thought.

So I am fairly confident that a "workable" solution will be reached before the markets open on Monday.  I do not look for an "optimal" solution.  If an optimal solution exists, it is undoubtedly too complicated to be "workable".  But I believe that a number of ideas on the table have the potential to avert a complete meltdown.  I think that when all the parties (including both McCain and Obama) meet behind closed doors and really come to grips with the magnitude of the problem and the fact that a workable solution exists, we'll get one.

I sure hope I'm right.

By the way, today's award for the best job of explaining the consequences of inaction and the issues inherent in the different approaches to a solution goes to Peter Orszag of the CBO for his testimony to the House Budget Committee.  His complete statement is on the CBO Director's blog.  Excellent explanation.

From the NY Times:

Sweden did not just bail out its financial institutions by having the government take over the bad debts. It extracted pounds of flesh from bank shareholders before writing checks. Banks had to write down losses and issue warrants to the government.

That strategy held banks responsible and turned the government into an owner. When distressed assets were sold, the profits flowed to taxpayers, and the government was able to recoup more money later by selling its shares in the companies as well.

Worth a look.

Here's the NY Times article explaining it.  Calculated Risk explains why it's not quite like the RTC.  Actually, the buying of distressed mortgages from banks that don't want them sounds more like the original Fannie Mae.  There is an important difference from Fannie Mae in that this does not appear to be permanent.  Its temporary nature is one point of similarity with the RTC.  I think we'll just have to wait and see what it looks like when it's all said and done.

I haven't had time to think about it enough to have an opinion.  I'll probably wait until the details are out.  I do have some questions though.  One thing I don't have a feel for is how much of a discount will be taken when the government purchases these assets and what they'll be worth when the government sells them.  Just how quickly will the plan restore these balance sheets to something approaching normal?  For all the attention the other interventions have received, this one has the potential to really be The Big One.

Doesn't the fact that overseas markets are surging in response to this make you the least bit nervous about how this will be interpreted?

What will become of the $70 billion private liquidity fund?  Will it even be tapped now that The Big One is on the horizon?

My working hypothesis is that the connectedness of the markets made this simply impossible to unravel piece-by-piece.

It's been a while since I've said this, but my sentiment right now is approximated most closely by Paul Krugman's latest column.  Go.  Read.  Understand.

This one comes from Lawrence White at Division of Labour.  It's a Forbes article on the Shadow Financial Regulatory Committee (which is sponsored by the American Enterprise Institute).

Washington, D.C. -

An independent panel of academics Monday cautioned Washington against rushing into an innovation-stifling regulation of investment banking, but urged that structures be put in place to ensure the industry itself bears the cost of any future federal bailouts.

The Shadow Financial Regulatory Committee also took a stand against new restrictions on short-selling and recommended that the government liquidate Fannie Mae and Freddie Mac once the market for mortgage financing has stabilized. The federal government took over the two quasi-private mortgage giants earlier this month.

...

The committee noted approvingly that the Federal Reserve Bank of New York has been pushing industry players to create a central clearinghouse for credit default swaps and other derivatives. In a clearinghouse model, Calomiris said, investment banks would share the costs of a member's default, thus creating an incentive to enforce capital standards and to demand more transparency from other participants.

The committee also recommended that the federal government levy a special assessment on investment banks to pay for any future industry bailouts, thus giving the bankers an incentive to support federal intervention only when a failure would present a true risk to the financial system.

The model for this, the committee noted, was established when Congress passed the Federal Deposit Insurance Corporation Improvement Act of 1991.

...

The $70 billion liquidity fund that 10 financial institutions, including Citigroup, Credit Suisse and Deutsche Bank, agreed to set up over the weekend was an acknowledgment by these institutions that it's appropriate for them to share losses to contain systemic risk, the committee noted.

In his post, White adds:

If the Fed and Treasury are now giving a de facto guarantees to the creditors of investment banks (as in the Bear Stearns intervention), why not require the Fed or Treasury to recoup the cost through an assessment on all investment banks? That would insulate ordinary taxpayers, and it would give healthy investment banks an incentive to oppose unnecessary bailouts. Ditto for guarantees to the creditors of insurance companies (as in the AIG nationalization).

It is a bad idea to extend federal guarantees to the creditors of investment banks and insurance companies. First-best is to let those industries organize their own cross-supports (on the model of pre-Fed bank clearinghouses) if they think it worthwhile. But extending federal guarantees to an industry at a zero price, subsidized by ordinary taxpayers, is the worst idea of all.

I could certainly get behind such a proposal going forward.  The liquidity fund setup over the weekend is definitely a step in the right direction.  To the extent that the Fed and Treasury used moral suasion to make it happen, they deserve some credit.  Providing government guarantees to insurance companies is not something that I like to see either, but I'm willing to give the benefit of the doubt to the front line troops in the heat of battle.  I would agree that for the next firm in this position, the Fed and Treasury need to lean on them really hard to use the private liquidity fund.  I mean really hard.

Another good comparison that may be more familiar to people would be the way that we fund unemployment insurance.  Unemployment insurance is funded by a tax on employers that is experience rated.  That is, firms that have more layoffs are taxed more heavily.  Likewise, the government could set up an assessment (i.e. tax) on investment banks, perhaps even make it dependent on an audit of their financial position and transparency.  I think that idea deserves some attention.

There is a way forward.  And it is definitely appropriate to start thinking creatively about ways to prevent the moral hazard which could lead to another crisis.  The door is broken and the cows are out of the barn.  Our first priority is rounding up the cows, but it doesn't hurt to put a few smart minds to work on the problem of fixing the door--it may even keep in some of the cows that have not yet escaped.

Here's an interesting comment from the WSJ MarketBeat blog:

"With this move the Fed and Treasury have blinked in the face of market pressure once again," writes Drew Matus, economist at Merrill Lynch. "They continue to react to situations rather than getting in front of them and now they have created uncertainty about what firms qualify for bailouts and which do not."

Let's think about this.  If there was an easy way to tell which firms pose the most potential for systemic risk and if the Fed started to "get out in front" of those situations, what do you think the result would be?

Yeah.  Not pretty.

A little uncertainty is a good thing here.

The other important thing to remember in all this is that the size of the AIG "bailout" may be much less than the $85 billion that has people worked up.  This is really just an extension of the Fed's credit facilities that have always been available to commercial banks and have recently been extended to investment banks.  AIG would not qualify for such help from the lender of last resort, but the harm to the system from its failure would be at least as great as the harm from failures of a traditional bank.  Therefore the Fed used its emergency power to extend that credit to them.  AIG will essentially reorganize as if it were going through bankruptcy but without the agony to the system that a bankruptcy would cause.  There's a very real probability that the Fed could come out ahead on this deal.

Tyler Cowen explains why no one else was willing to do it, and Felix Salmon also agrees with me on the possible upside.

The next big problem in the short term is getting the money market through all of this.  No sighs of relief until they are, at least temporarily, out of the woods.

Here's the statement from the Fed:

The Federal Reserve Board on Tuesday, with the full support of the Treasury Department, authorized the Federal Reserve Bank of New York to lend up to $85 billion to the American International Group (AIG) under section 13(3) of the Federal Reserve Act. The secured loan has terms and conditions designed to protect the interests of the U.S. government and taxpayers.

The Board determined that, in current circumstances, a disorderly failure of AIG could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth, and materially weaker economic performance.  

The purpose of this liquidity facility is to assist AIG in meeting its obligations as they come due. This loan will facilitate a process under which AIG will sell certain of its businesses in an orderly manner, with the least possible disruption to the overall economy. 

The AIG facility has a 24-month term. Interest will accrue on the outstanding balance at a rate of three-month Libor plus 850 basis points. AIG will be permitted to draw up to $85 billion under the facility. 

The interests of taxpayers are protected by key terms of the loan. The loan is collateralized by all the assets of AIG, and of its primary non-regulated subsidiaries.  These assets include the stock of substantially all of the regulated subsidiaries.  The loan is expected to be repaid from the proceeds of the sale of the firm's assets. The U.S. government will receive a 79.9 percent equity interest in AIG and has the right to veto the payment of dividends to common and preferred shareholders.

The Wall Street Journal gives a very thorough rundown of all the details.

Opinions are surely going to be divided on whether this is a good thing or not.  John Jansen sees the Fed as "careening down a very slippery slope".  I have a feeling that most commentators will be against it even though their specific reasons will differ.

Mark Thoma thinks it is a good idea.  And while I would have rather seen them tap the private equity market, something had to be done.  Recall that AIG has been turning down private assistance for the last couple days because they didn't want to give up control of the company.  With the Fed deal, they will surely give up some control, but exactly what the company will look like going forward remains to be seen.

Is it a bailout?  Is it a takeover?  To me it looks more like bankruptcy by another name.  Effectively it gives AIG some time to sell a lot of its assets--more than just the junk--and reorganize itself.  In the meantime, its creditors will be made whole.  Equity holders may properly bear some of the cost as the government has veto power over dividends.  At the end of the 24 month period...hopefully...the company, in whatever form it takes, can resume something approaching normalcy.  Assuming, of course, that it has any reputation left.  Perhaps sometime during or after that 24 months a suitable buyer can be found.  These are questions that no one can answer now.

Make no mistake, this is not something that the Fed should enter into lightly, and I am quite confident that they took this step only when it became apparent that it was the last option.  But this might have been one of those turning points where a decisive action had to be made.  Anyone who has not read chapter 7 of Friedman and Schwartz needs to do so right now.  Every time I tell a macroeconomics class about the mistakes the Fed made in the Great Depression, I end by talking about the many things we have learned since then about how not to let it happen again.  Few people know those lessons better than Mr. Bernanke.  Dithering in the face of these problems only makes them worse.  Better to have swift decisive action and move toward a resolution.

To those who say that this fails to properly punish those who took excessive risk, I agree in part but can only say that protecting the innocent (or perhaps less guilty) is more important right now than punishing the truly guilty.  To those who would say that this is an affront to the free market system, I would simply say that without confidence in market institutions the system doesn't work.  The system's ability to restore that confidence has been compromised by the foolish actions of many people.  Some will get their comeuppance.  Some will not.  It's not a perfect world.  We'll try to reform the system so as to do better next time.  Right now let's focus on doing it better than last time.

In a nice commentary, Calculated Risk appears cautiously optimistic.

There will be more grim news, perhaps for another year or more. And there is definitely some possibility of a systemic financial collapse (see Professor Roubini's excellent discussion of the downside risks). But unlike observers that believe this only marks the end of the beginning, I believe there is a chance that these events mark the beginning of the end of the crisis.

As I said yesterday, I think the end game has begun.  Clearly the push to mark down the values of these assets is in full swing.  The AIG deal could be a catalyst for an orderly sale of these assets, a rebalancing of portfolios, and a fair market valuation of assets on the books of other firms.  In the process, we might find other AIGs, but more than likely any of the truly enormous problems will be discovered first, and that process may not take too long.  Several months, perhaps--but not several years.  Indeed, we are fortunate that these problems are being discovered and dealt with rather than festering for a decade or more.

I've been in class all day, so I haven't had a chance to write about the days events.  Actually, there's not that much more to say other than that I really admire the fact that the Fed held the line on interest rates today.  As I said yesterday, the crisis is one of quantity, not of price.  The new lending facilities are much more important and useful than a 25 basis point cut in the funds rate.  So my confidence has been buoyed by this news.

Here's the link to the Fed's press release.

The Federal Open Market Committee decided today to keep its target for the federal funds rate at 2 percent.

Strains in financial markets have increased significantly and labor markets have weakened further. Economic growth appears to have slowed recently, partly reflecting a softening of household spending. Tight credit conditions, the ongoing housing contraction, and some slowing in export growth are likely to weigh on economic growth over the next few quarters. Over time, the substantial easing of monetary policy, combined with ongoing measures to foster market liquidity, should help to promote moderate economic growth.

Inflation has been high, spurred by the earlier increases in the prices of energy and some other commodities. The Committee expects inflation to moderate later this year and next year, but the inflation outlook remains highly uncertain.

The downside risks to growth and the upside risks to inflation are both of significant concern to the Committee. The Committee will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Christine M. Cumming; Elizabeth A. Duke; Richard W. Fisher; Donald L. Kohn; Randall S. Kroszner; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh. Ms. Cumming voted as the alternate for Timothy F. Geithner.

My quick take is that it is very noncommittal about whether any rate cuts are forthcoming.  The inflation pressure still figures prominently in the press release, though they do expect inflation to ease.  This is an announcement that leaves all avenues open--and that is a very good thing.

In my intermediate macro class today, I lectured against a backdrop of the live (well, actually slightly delayed) tick-by-tick chart of the fed funds futures on the CBOT.  I was teaching macroeconomics as it happened.  You don't get to do that very often.

Seems like the big questions on everyone's mind are whether there will be some kind of development with AIG tomorrow, which firms are most exposed to Lehman, and whether the Fed will cut interest rates.  It goes without saying that everyone is also wondering about whether and how much the Dow may fall.  As I write, the futures market is down, but not drastically, suggesting that the day may start on a down note.

I can't say much about the first two.  But let's think about the Fed for a minute.  When I wrote in the afternoon, it looked like the market was only pricing in a small probability of a rate cut.  Late night coverage on CNBC suggests that the probability has increased substantially now.

The Wall Street Journal acknowledges the uncertainty:

Federal Reserve officials aren't inclined to veer from plans to hold short-term interest rates steady at Tuesday's meeting, even though financial markets are putting strong odds on a quick rate cut.

The Fed's thinking could change, particularly if there is another sharp deterioration in markets and the financial sector Tuesday. And even if officials decide to stay on hold, they could signal in their end-of-meeting statement a greater willingness to consider rate cuts if the economy or markets worsen.

A rate cut would be a confidence booster, to be sure.  Ordinarily, one might expect a rate cut in this case would prevent the financial market problems from spreading to Main Street.  I'm not sure that 25 basis points (or even 50) would really have much of an effect in that regard.  Plus, if the Fed were to cut 50 b.p. tomorrow (as some are expecting), it leave only another 1.50% to go before hitting the zero lower bound.  Given that this could go on for a while, it is imperative that they hold back some ammunition just in case things get much worse.

But most importantly, I don't see how 25 points (or even 50) does anything substantial to ease the credit crisis that the expansion of the quantity of credit through the various lending facilities can't do.

In the end, they may decide that a 25 or 50 point move is necessary to inspire confidence.  I would like to think that in the last year the market has wised up in that regard and can understand that this problem will not be solved by a rate cut any time a financial firm runs into trouble.

These are momentous times, the likes of which we will be talking about for years to come.

I watched the press conference with the John Thain and Kenneth Lewis (CEOs of Merrill Lynch and Bank of America, respectively) as well as the CNBC interview with Lewis.  Mr. Lewis looked like the cat that ate the canary.  He certainly gives the impression that this is the deal of a lifetime.  Who knows?  He may be right.

At this point, I have begun to make a few inferences.  We'll see how accurate they turn out to be.

1. Based on CNBC's reporting, it sounds like Merrill Lynch really cleaned up their act (and their books) in the last few months.  They make it sound like Merrill might have even been able to survive this crisis without being sold.  That's encouraging.  Perhaps some of the other firms that are in less dire condition may be able to heal themselves, even if it takes some time for it to all work out.
2. Either Lehman's position in the market must have been significantly different than that of Bear Stearns a few months ago, or the market is better equipped to deal with a failure of that magnitude.  Both could be true as well.  There was no cataclysmic market meltdown this morning.  Contrast that with the speculation on what might have happened this spring if Bear Stearns had declared bankruptcy.  This is also encouraging.
3. Remember when people criticized the Fed for taking part in the rescue of Bear Stearns?  Remember when people said that it would create moral hazard and make it difficult for the Fed to say no next time?  Well, apparently the Fed is stronger than a lot of people gave them credit for.  While I don't think Mr. Bernanke expected it to play out exactly this way (who would have?), I do applaud him for taking the action with Bear Stearns to prevent the first incident from being such a shock to the system.  A lot of people wanted a sacrificial lamb.  Mr. Bernanke may have been correct in thinking that a better candidate than Bear Stearns would come along.
4. AIG's potential collapse sounds like it would have a greater impact than Lehman's.  I think the Fed is right to hold the line.  The announcement from the governor of New York will help.  The growing pool of private equity might help too.  And of course someone might ride to their rescue as well.
5. Expect another year of write-downs, bankruptcies, and mergers.  But I think that the end game has begun.  By that, I do not mean that the danger is over or that things will get eaiser.  When I say that the end game has begun, I mean that the deals will start happening at a quicker pace in the next 12 months than in the last 12 months and that each one will bring a bit of relief, however slight.  The financial markets will probably not be over this until 2010, and even then they won't be at pre-crisis strength.

So then there is the matter of the FOMC meeting tomorrow.  September futures on the Chicago Board of Trade jumped a little bit this morning on all of the news, but have pulled back a bit.  Traders are pricing in a significant probability of at least a 25 basis point cut.  However, it is far from a sure thing.  I'm hoping they don't.  I don't think they want to.  The expansion of the various lending facilities should do more to ease the strain than a 25 basis point cut anyway.  Plus there is the obvious fact that they would like to save some ammunition in case it is needed later if things don't play out as well as they might.

Let's see how things go tomorrow.

It certainly says something when firms that survived the Great Depression are falling victim to the aftermath of the last decade's credit binge.

And so the venerable Lehman Brothers passes from the scene at the age of 158.  When the sun rises in the morning, we will see how Wall Street deals with this development.  Of course, many people were expecting this, and undoubtedly made contingency plans.  By Friday, it seemed that a Sunday night announcement was almost a sure thing.  After all, we went through this once before with Bear Stearns.  Yet, even though this was possibility for the past few weeks and months, it is now reality.

It is interesting that Bank of America, which as of Friday many people were expecting to buy Lehman, took a pass on that deal and is instead buying the troubled (and storied) Merrill Lynch.  How's that for misdirection? 

But that's not all.  Showing once again that bad things do indeed come in threes, the insurance giant AIG is also in need of assistance.

With these three companies in such dire straits, the Federal Reserve did what it could... quoting in part:

The Federal Reserve Board on Sunday announced several initiatives to provide additional support to financial markets, including enhancements to its existing liquidity facilities. 

"In close collaboration with the Treasury and the Securities and Exchange Commission, we have been in ongoing discussions with market participants, including through the weekend, to identify potential market vulnerabilities in the wake of an unwinding of a major financial institution and to consider appropriate official sector and private sector responses," said Federal Reserve Board Chairman Ben S. Bernanke. "The steps we are announcing today, along with significant commitments from the private sector, are intended to mitigate the potential risks and disruptions to markets."

"We have been and remain in close contact with other U.S. and international regulators, supervisory authorities, and central banks to monitor and share information on conditions in financial markets and firms around the world," Chairman Bernanke said.

The collateral eligible to be pledged at the Primary Dealer Credit Facility (PDCF) has been broadened to closely match the types of collateral that can be pledged in the tri-party repo systems of the two major clearing banks. Previously, PDCF collateral had been limited to investment-grade debt securities.

The collateral for the Term Securities Lending Facility (TSLF) also has been expanded; eligible collateral for Schedule 2 auctions will now include all investment-grade debt securities. Previously, only Treasury securities, agency securities, and AAA-rated mortgage-backed and asset-backed securities could be pledged.

By expanding the types of collateral accepted, the Fed addressing the need for liquidity by immediately expanding the quantity available.  At this point, that is what is needed (as opposed to any action on interest rates).

Justin Fox has a pretty good summary:

We'll learn much more about the exact chain of events over the coming days and weeks and months, but the basics go something like this: New York Fed boss Tim Geithner (and his pals from Washington) tried to figure out some way to avert the failure of Lehman Brothers without offering any kind of federal guarantee. But nobody wanted to buy Lehman without help from Uncle Sam, so it looks like Lehman will go under. Which meant Merrill Lynch would take over Lehman's spot as Most Obviously Troubled Investment Bank. So Merrill sold out to Bank of America at $29 a share ($44 billion total). Which is an awful lot less than the $97 a share Merrill was selling for a year-and-a-half ago, but also a lot more than nothing.

So on Monday we'll get to see what the failure of an investment bank with $600 billion in assets looks like. And more important, we'll get to see if the obviously deeply flawed American financial system will be able to retain the confidence of the foreign lenders and investors who keep it going.

One crucial thing to remember in all of this is that none of the experts on Wall Street have any real idea of what they're dealing with. What has worked for the past quarter century or so has stopped working. And nobody knows what American financial institutions are going to look like going forward. Probably a lot more like the universal banks of Continental Europe. But anybody who says they know for sure is lying.

Want to read a little history about the last time something like this happened?  Here's what the NY Times had to say about Drexel Burnham Lambert in 1990.  It reads a lot like today's news, right down to the weekend meetings.  Just replace "junk bonds" with "subprime mortgages".

There are some differences, of course.  The biggest difference is that there are still so many firms in similar condition that there is no guarantee that this crisis is over.  I think that Fox is right in saying that "anyone who says they know [what American financial institutions will look like after this] for sure is lying."  But I am confident that the system will get through this very troubling time.

As this Wall Street Journal piece by Justin Lahart points out, there needs to be quick and decisive action to prevent something like what happened in Japan during the 1990s.  The sooner everybody confronts that reality, the quicker we can get back to business.  It is good to get the "unwinding" process started as soon as possible.  Make sure that the smaller firms don't become collateral damage from counterparty risk, and let the consolidation result in the inevitable (but probably only short-to-medium run) shrinkage of the sector.

Every time one of these trouble firms is finally taken aside and shown the handwriting on the wall, we take one more step toward the day when someone gets to write one pretty massive after-action report.  And of course, now that the extent of the damage to these three firms has been revealed, the rush is on to find who is next.  Until the answer to that question is "no one", there will be more rough days ahead.  I don't think we're there yet.

John Jansen has some excellent commentary and I'm sure will be adding more in the morning.  He is quite worried about how all of this will end.

Government has not been able to hold bank the forces which have taken down financial giant after financial giant. Capitalism demands pain. Good risk is rewarded and imprudent risk is punished. We were engaged in an orgy of imprudent risk taking for nearly a decade and now a heavy price will be paid for the violation of so many simple and common sense precepts of trading.

Very true.  On a related topic, Tyler Cowen opines in the NY Times:

There is a misconception that President Bush's years in office have been characterized by a hands-off approach to regulation. In large part, this myth stems from the rhetoric of the president and his appointees, who have emphasized the costly burdens that regulation places on business.

But the reality has been very different: continuing heavy regulation, with a growing loss of accountability and effectiveness. That's dysfunctional governance, not laissez-faire.

Blame enough to go around, to be sure.  Like I said, it's going to be some after-action report.

Mark Thoma has a good collection of links for your morning reading as well.

Buckle up.  It could be an interesting day.

UPDATE:  Here's one more comment on the AIG situation.  First the Wall Street Journal:

During a weekend scramble to shore up its finances, AIG turned down a capital infusion from a group of private-equity firms led by J.C. Flowers & Co. because an option tied to the offer would have effectively given them control of the company, an 89-year-old giant that does business in nearly every corner of the world.

Which prompted Yves Smith of Naked Capitalism to say:

That is not going to endear them to the Fed, turning down a deal, particularly when Merrill did the right thing and sold itself to avert a possible systemic event. This is brassy and risks overplaying their hand. If I were the powers that be, I'd tell them to stuff it and take the deal.

Indeed.  I think the Fed is really trying to limit the taxpayers' exposure on this one.  If AIG turns down a deal, it gives others license to do so.  I don't like where that leads.

From the BLS,

The unemployment rate rose from 5.7 to 6.1 percent in August, and non-farm payroll employment continued to trend down (-84,000), the Bureau of Labor Statistics of the U.S. Department of Labor reported today. In August, employment fell in manufacturing and employment services, while mining and health care continued to add jobs. Average hourly earnings rose by 7 cents, or 0.4 percent, over the month.

Series Id:           LNS14000000
Seasonal Adjusted
Series title:        (Seas) Unemployment Rate
Labor force status:  Unemployment rate
Type of data:        Percent
Age:                 16 years and over

One of the burning questions in my mind right now is when the NBER Business Cycle Dating Committee will declare that the recession began (and when they will make the announcement (see Brad DeLong's comment).

But this is an odd one, in part for the reasons stated by David Altig.  Altig stops short of calling this a recession, but contrasts the strong GDP data and the weak employment data as he pities the Business Cycle Dating Committee for the tough job they have ahead.

How do you square 3.3% GDP growth with a 0.4% increase in the unemployment rate?

As I pointed out earlier, the GDP growth is largely due to the falling dollar.  It's great if you're an exporter, but it does nothing to ease the pain in the housing sector.    And as the WSJ Real Time Economics blog pointed out, Gross Domestic Income paints a somewhat less rosy picture.  The unemployment rate, usually a lagging indicator, is looking more coincident, but that may be because the weakness in the economy is being masked somewhat.

There is little doubt in my mind that we are in a period that should be called a recession.  I could guess at when the starting date would be, but it would be just that--a guess.  I could make a case for sometime in the spring or summer.  And while I admit to being troubled by thinking of a recession in the shadow of 3.3% GDP growth, I am struck by some very strong differences between this recession (if it is one) and the last two.  The usual definitions aren't fitting well.

There's going to be a lot to talk about this fall.  I'm working on the local economic outlook and giving a presentation on it a week from tomorrow.  Lucky me.

Real GDP was up 3.3% in the 2nd quarter.  That's more than most expected.  Certainly not what you'd expect to see in a recession.  It should be noted that this is not a clean bill of health for the economy.  It would be premature to say that we're out of the woods.  However, if this is a recession, it would be a pretty unusual one.  As King Banaian put it a couple days ago in response to labor market news, "If it be recession, it be wimpy."  And so today's news further complicates the picture.

Just what I needed as I sit in contemplation as I prepare to write about the local economic outlook.

The Wall Street Journal's Real Time Economics blog makes the following observation:

But the forecasts of a shrinking economy may not be so far off the mark after all. Gross domestic income, which Fed officials have in the past highlighted as perhaps a better measure than GDP, advanced just 1.9% at an annual rate last quarter after contracting the two previous quarters. Thursday's report is the first to show first quarter GDI in the red.

...

GDP is a consumption-based measure, adding up consumer, business and other spending and investment as well as net exports. GDI is income-based, adding up things like personal income and corporate profits. GDI is included in quarterly GDP, but not in the first, or "advance," estimate, so Thursday's report was the first for second quarter GDI.

In theory, the two should equal each other, but they don't always. In recent quarters, net exports seem to be the main reason, since they flow directly into GDP but only indirectly into GDI. In addition, GDI more heavily reflects corporate profits than GDP does.

Before-tax corporate profits grew slightly in the second quarter after falling the previous two quarters. The difference between GDI and GDP is more than just academic.

In a Fed paper released last year, Fed economist Jeremy Nalewaik wrote that "real-time GDI has done a substantially better job recognizing the start of the last several recessions than has real-time GDP." Fed officials have even taken notice. According to the Fed's May 2007 meeting minutes, when economic data were giving mixed signals on the economy's underlying state, Fed officials "discussed how best to reconcile the slowdown in output growth over the past year with the relatively strong performance of the labor market."

"This apparent tension could partly reflect measurement issues; in particular, participants noted that the more-rapid gains in estimates of gross domestic income over this period might better capture the pace of activity than the modest advances in measured GDP," the minutes said.

Now that the two measures have flipped with GDI lagging, it seems likely that Fed officials will now take 3%-plus GDP growth with a big grain of salt.

True.  One other thing to consider is how much the weakening dollar is helping GDP by reducing the trade deficit.  Exports are growing rapidly while (real) imports are shrinking.  The real trade deficit (quarterly SAAR) is about a third less than it was a year ago.  That's pretty significant, and definitely accounts for some of the increase in GDP.

In fact, the contribution of net exports to real GDP growth last quarter was 3.1%.

Out of 3.3%.

While I still think that the Fed's next move will be to raise interest rates rather than lower them, I admit to being a little concerned that a rate hike too soon might strengthen the dollar before we're ready.

Mark Thoma has more.

Obviously a lot of people were hoping for some insight on inflation and the course of interest rates. However, the real story is here: (Full text of Bernanke's speech)

An effective means of increasing the resilience of the financial system is to strengthen its infrastructure. For my purposes today, I want to construe "financial infrastructure" very broadly, to include not only the "hardware" components of that infrastructure--the physical systems on which market participants rely for the quick and accurate execution, clearing, and settlement of transactions--but also the associated "software," including the statutory, regulatory, and contractual frameworks and the business practices that govern the actions and obligations of market participants on both sides of each transaction. Of course, a robust financial infrastructure has many benefits even in normal times, including lower transactions costs and greater market liquidity. In periods of extreme stress, however, the quality of the financial infrastructure may prove critical. For example, it greatly affects the ability of market participants to quickly determine their own positions and exposures, including exposures to key counterparties, and to adjust their positions as necessary. When positions and exposures cannot be determined rapidly--as was the case, for example, when program trades overwhelmed the system during the 1987 stock market crash--potential outcomes include highly risk-averse behavior by market participants, sharp declines in market liquidity, and high volatility in asset prices. The financial infrastructure also has important effects on how market participants respond to perceived changes in counterparty risk. For example, during a period of heightened stress, participants may be willing to provide liquidity to a market if a strong central counterparty is present but not otherwise.

and here...

Going forward, a critical question for regulators and supervisors is what their appropriate "field of vision" should be. Under our current system of safety-and-soundness regulation, supervisors often focus on the financial conditions of individual institutions in isolation. An alternative approach, which has been called systemwide or macroprudential oversight, would broaden the mandate of regulators and supervisors to encompass consideration of potential systemic risks and weaknesses as well.

The latter is, of course, much easier said than done. It will be interesting to see what sort of ideas come out of the conference.

This was expected. Here's the statement.

The Federal Open Market Committee decided today to keep its target for the federal funds rate at 2 percent.

Economic activity expanded in the second quarter, partly reflecting growth in consumer spending and exports. However, labor markets have softened further and financial markets remain under considerable stress. Tight credit conditions, the ongoing housing contraction, and elevated energy prices are likely to weigh on economic growth over the next few quarters. Over time, the substantial easing of monetary policy, combined with ongoing measures to foster market liquidity, should help to promote moderate economic growth.

Inflation has been high, spurred by the earlier increases in the prices of energy and some other commodities, and some indicators of inflation expectations have been elevated. The Committee expects inflation to moderate later this year and next year, but the inflation outlook remains highly uncertain.

Although downside risks to growth remain, the upside risks to inflation are also of significant concern to the Committee. The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Elizabeth A. Duke; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh. Voting against was Richard W. Fisher, who preferred an increase in the target for the federal funds rate at this meeting.

A few changes since the last statement. The part about the "substantial easing of monetary policy, ... should help to promote moderate economic growth" was moved from toward the end of the statement to near the beginning. The paragraph on inflation has been rewritten with more of a direct acknowledgment of inflation being high and the outlook uncertain.

But pay attention to the last paragraph.

August 5:

Although downside risks to growth remain, the upside risks to inflation are also of significant concern to the Committee. The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability.

June 25:

... Although downside risks to growth remain, they appear to have diminished somewhat, and the upside risks to inflation and inflation expectations have increased. The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability.

The phrase about downside risks to growth having diminished has been taken out, as has the phrase about inflation expectations increasing (today they are, rather, a "significant concern").

So what does it mean to be a significant concern? Ask the stock market. As I write, the Dow Jones is up over 300 points.

The stock market doesn't seem to buy their concern. It looks like no change in rates for the foreseeable future.

You didn't really think they'd raise rates at this meeting, did you? Here's the full statement:

The Federal Open Market Committee decided today to keep its target for the federal funds rate at 2 percent.

Recent information indicates that overall economic activity continues to expand, partly reflecting some firming in household spending. However, labor markets have softened further and financial markets remain under considerable stress. Tight credit conditions, the ongoing housing contraction, and the rise in energy prices are likely to weigh on economic growth over the next few quarters.

The Committee expects inflation to moderate later this year and next year. However, in light of the continued increases in the prices of energy and some other commodities and the elevated state of some indicators of inflation expectations, uncertainty about the inflation outlook remains high.

The substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time. Although downside risks to growth remain, they appear to have diminished somewhat, and the upside risks to inflation and inflation expectations have increased. The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh. Voting against was Richard W. Fisher, who preferred an increase in the target for the federal funds rate at this meeting.

Michael Mandel thinks that the Fed should have cut. I haven't seen too many others jump on that bandwagon. Barry Ritholtz thinks that statement is "too cheery on growth, not concerned enough about inflation -- and is totally irrelevant". Mark Thoma does the side-by-side with the last statement and writes that "There aren't many clues about the future in the statement..."

I don't know about that. I happen to think that this statement paves the way for standing pat for the rest of 2008. They seem to be extending the time horizon for when to expect inflation pressures to moderate ("later this year and next year") and they took out the part about it being necessary to "monitor inflation developments carefully".

So Mandel thinks a cut is in order. One can speculate about what a Greenspan Fed might have done in this situation. I certainly know what Wall Street would like. In the face of that, it seems that Mr. Bernanke might be following the right course. He's waiting for real rates to come up on their own as the economy recovers. I think that's the way to interpret it, and I think this course is less bad than some of the other options.

From the dissenters at the last couple of meetings, it looks like Fisher is trying to stay one step more hawkish than the chairman--now dissenting by voting for a rate hike in the face of the majority holding steady (previously he voted to hold steady when the majority wanted a cut). Plosser's votes (dissenting by voting to hold steady rather than cut in April but voting with the majority to hold steady now) are probably more fundamentally in line with Bernanke's thinking about where they want to be down the road (assuming the inflation forecasts are right), but he looks to have wanted a little bit more of a start at getting the real rate up where it should be.

If inflation shows any progress downward, I think they'll stay here as long as they can. If not, then rates probably go up in 2009. But this statement gives me the impression that they are prepared to give inflation some more time before they pull the trigger.

The Fed posted their minutes from the last FOMC meeting today. Check out the charts at the back that show the shift in the forecasts of the participants on variables such as GDP and inflation going out to 2010. There has been a noticeable shift since January. However, it does appear that the last meeting will be the last rate cut for a while. The Wall Street Journal's Brian Blackstone has a good summary of the minutes.

See also Donald Kohn's speech from yesterday.

Janet Yellen is on the lecture circuit. (Reuters)

"The 1970s were a horrible period. If there's one thing that has to be very high priority, we don't want to go back to a period that is anything like that," she said, critiquing presentations on the economy at a symposium for college students in Tacoma, Washington.

She is, of course, talking about inflation (not bell-bottoms or disco).

"During the 1970s the Fed failed to keep inflation low in the face of supply shocks (which) became incorporated into inflation expectations," Yellen said.

She acknowledges, as I think most of us do, that this is not a simple problem with a simple answer. She's worried about the prospects of lower growth as well. But the fact that she, as one of the more dove-ish members of the committee, is talking about inflation risks is a sign that the tide may have turned.

Reuters carried the story a few days ago and somehow I missed it.

WASHINGTON (Reuters) - The Federal Reserve's Board of Governors will hold a closed meeting on Wednesday [Apr. 30] to discuss paying interest on bank reserves, one of a number of options officials have been mulling to address liquidity problems in financial markets in case measures taken to date fail to gain traction.

This is not a sudden development, as the article goes on to point out...

Congress in 2006 granted the Fed authority beginning in 2011 to pay interest on bank reserves. At the time, the central bank assigned staff to study the implications such a move could have on its operations.

The staff report is now ready and will be presented to the Fed during the regularly scheduled meeting of its interest-rate setting panel, a Fed official added, declining to comment further on whether the presentation is pegged to any imminent steps to boost liquidity.

This was scheduled to go into effect in 2011, but they are looking for approval to start doing it now. I think that's a good idea. It is certainly not without precedent. Other central banks do it, including our neighbor to the north.

Now, the fact that this was passed back in 2006 went largely unnoticed, but not here. In fact, I even gave you a scholarly reference...

The October minutes are on the Fed's web site. Here's the first thing that caught my eye.

The Chairman noted that the President had recently signed the Financial Services Regulatory Relief Act of 2006, which among its provisions gave the Federal Reserve discretion, beginning October 2011, both to pay interest on reserve balances and to reduce further or eliminate reserve requirements. The Act potentially has important implications for many aspects of the Federal Reserve's operations and the Chairman asked Vincent Reinhart, Director of the Division of Monetary Affairs, to form a committee of Federal Reserve System staff to consider these issues.

They could learn from Canada, the UK, and New Zealand, as this publication by Sellon and Weiner from the Kansas City Fed explains.

And here's a technical paper on how the Bank of Canada does it.

I'll go on the record that this is a good idea. It will help to smooth out the recent fluctuations in the funds rate that garnered so much consternation at this blog among other places. It would prevent interest rate policy from getting in the way of policies for directly injecting liquidity into the financial markets by effectively keeping a floor on the funds rate even during a big injection of liquidity.

Fed Governor Donald Kohn spoke about it back in 2004 as well.

Hat tip to Barry Ritholtz and the WSJ.

UPDATE: Mark Thoma thought of it too.

My class was right... including about who the dissenters would be. (Though they actually predicted more dissent, I cautioned them that two was probably the most you'd see in the vote.) Not that this was a particularly hard call. On the surprise meter, today's move by the Fed--from the amount and direction of the change to the dissenters to the apparent shift in stance going forward--barely registers. Indeed, what is there to say that hasn't been said already?

For the record, here is the statement from the Fed:

The Federal Open Market Committee decided today to lower its target for the federal funds rate 25 basis points to 2 percent.

Recent information indicates that economic activity remains weak. Household and business spending has been subdued and labor markets have softened further. Financial markets remain under considerable stress, and tight credit conditions and the deepening housing contraction are likely to weigh on economic growth over the next few quarters.

Although readings on core inflation have improved somewhat, energy and other commodity prices have increased, and some indicators of inflation expectations have risen in recent months. The Committee expects inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization. Still, uncertainty about the inflation outlook remains high. It will be necessary to continue to monitor inflation developments carefully.

The substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time and to mitigate risks to economic activity. The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; Sandra Pianalto; Gary H. Stern; and Kevin M. Warsh. Voting against were Richard W. Fisher and Charles I. Plosser, who preferred no change in the target for the federal funds rate at this meeting.

In a related action, the Board of Governors unanimously approved a 25-basis-point decrease in the discount rate to 2-1/4 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of New York, Cleveland, Atlanta, and San Francisco.

There are two very obvious differences between this statement and the last (in addition to a few more subtle variations of the wording that are also consistent with the overall shift but probably not worth obsessing over). Those two obvious differences are that what was

Recent information indicates that the outlook for economic activity has weakened further.

is now...

Recent information indicates that economic activity remains weak.

The interpretation being that we may have "hit bottom," to put it rather bluntly. The other is that the sentence in the last statement...

However, downside risks to growth remain.

... is simply gone. Hard to be more obvious than that.

The inflation paragraph is interesting. There is some acknowledgment of the improvement in the core numbers. Also, the sentence in the last statement,

Still, uncertainty about the inflation outlook has increased.

Is now...

Still, uncertainty about the inflation outlook remains high.

As with the statement about economic activity, the implication is that while there hasn't been much improvement in the level, the first derivative looks better. It's almost as if an academic economist had a hand in crafting it.

Barring any new developments, expect no change in June.

Now, over to the GDP report. James Hamilton's post on the subject is my pick of the day for excellent analysis of the report. To tell you the truth, the GDP figure was pretty close to what most of us were expecting. Most expectations that I saw were in the positive-but-under-1-percent range. Also, it is important to remember that it is subject to revision, so I wouldn't make any big deal out of it beating expectations by a small fraction of a percent. It's what we expected, and it is not particularly good. The difference in economic activity over a 6 month period between growth of 3.5% and growth of 0.6% is a couple hundred billion dollars. Far from pocket change, that amount of lost economic activity in 6 months is roughly comparable to the current annual federal budget deficit.

But is it a recession? No. Not yet, anyway. And though some forecasts show an improvement in the 2nd half of 2008, we're not out of the woods yet. The increase in inventories and the accompanying decline in real final sales is particularly worrisome going into the 2nd quarter. The recovery from this slowdown (if not recession) will take some time.

In my intermediate macroeconomics course, the final project is a simulation of an FOMC meeting where members of the class play the roles of Fed officials. They did exceptionally well. The presentations and discussion were excellent.

My class voted 9 to 7 to cut by another quarter point. (The 7 wanting to hold rates steady)

As far as I can remember, my class has never been wrong, and also as far as I can remember, when the class predicts dissent, there usually, if not always, is (though never as much in the real vote).

It's an unscientific indicator, to be sure. But it is very rewarding to see the students take it so seriously and really learn about how the Fed works.

The real meeting, of course, is tomorrow. More on that later.

The IMF publication Finance & Development profiles John Taylor.

Hat tip: Greg Mankiw

From Reuters:

Goldman Sachs plans to test the program sometime this week, a spokesman said. Morgan Stanley Chief Financial Officer Colm Kelleher said his bank has already tested the program, and a spokeswoman for Lehman said the investment bank has also done so.

The Wall Street Journal reports that there still might be some stigma attached to borrowing from the Fed, but that the banks "viewed the new funding source positively".

The Real Time Economics Blog collected some reactions from Wall Street concerning the rate cut. One firm chose to emphasize their concerns about inflation.

These actions were taken despite rising inflation pressures. The Fed expects these pressures will subside as energy and other commodity prices flatten out, and as unused resources rise. Our take, however, is that commodity price strength is in part a function of the easy stance of monetary policy and that inflation is headed higher. –Bear Stearns

Contrast this with what they said in December, also from the pages of the Real Time Economics Blog:

The Fed continues to couch its policy actions in terms of their impact on economic growth rather than admit that the primary motivation for Fed action is the turmoil in the financing market — turmoil which may become worse as a result of the miserly action on the discount rate. –Bear Stearns

I guess it's all a matter of your perspective at the time.

From Felix Salmon:

I'm similarly skeptical about the idea that the Fed is "propping up" Bear Stearns. For a couple of months until it can be deleveraged and subsumed into JP Morgan, perhaps. But that's a world away from allowing banks to operate for years while marking distressed assets on their balance sheets at par, which is what happened in Japan. The Fed was happy leaving the carcass of Bear Stearns to the wolves at 270 Park: this was anything but a "propping up" operation.

Here's the statement.

The Federal Open Market Committee decided today to lower its target for the federal funds rate 75 basis points to 2-1/4 percent.

Recent information indicates that the outlook for economic activity has weakened further. Growth in consumer spending has slowed and labor markets have softened. Financial markets remain under considerable stress, and the tightening of credit conditions and the deepening of the housing contraction are likely to weigh on economic growth over the next few quarters.

Inflation has been elevated, and some indicators of inflation expectations have risen. The Committee expects inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization. Still, uncertainty about the inflation outlook has increased. It will be necessary to continue to monitor inflation developments carefully.

Today’s policy action, combined with those taken earlier, including measures to foster market liquidity, should help to promote moderate growth over time and to mitigate the risks to economic activity. However, downside risks to growth remain. The Committee will act in a timely manner as needed to promote sustainable economic growth and price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; Sandra Pianalto; Gary H. Stern; and Kevin M. Warsh. Voting against were Richard W. Fisher and Charles I. Plosser, who preferred less aggressive action at this meeting.

In a related action, the Board of Governors unanimously approved a 75-basis-point decrease in the discount rate to 2-1/2 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, and San Francisco.

I wonder what Fisher and Plosser would have preferred. 50? 25? 0? Maybe the minutes will tell us in a few weeks.

Parse it word by word if you want. Given the way that the last few days have gone, I'm not sure how much good it will do.

Judging by the way that Wall Street jumped in the first few minutes after, I would say that it was a little more than necessary. They could have gotten by with 50.

Anyway... got to run to class.

Anyone care to hazard a guess as to what they will do tomorrow?

The Cleveland Fed shows the above graph with the probabilities based on the fed funds futures. 75 basis points is the leader right now with 50, 100, and 125 (!) basis points all getting votes. The futures market is predicting a 50% probability of 1.5% by the next meeting. Clearly there are two likely ways that could happen--either 75 bp twice or 100 tomorrow and 50 next month. I'm not saying it can't happen.

But let's look at this coldly and rationally as we always do. What in the world would a 100 bp cut do to help the liquidity crisis (and the solvency crisis) that was at the root of this weekend's troubles? Nada. The announcement of the new lending facility did much more to steady everyone's nerves than a full percentage point cut ever will. Let's see if that works before spending more interest rate ammunition. How about 75 bp? Again, I'm hard pressed to say it will help the ways that are necessary. The market expects it, and as much as I'd like to say that the Fed should have the guts to disappoint the market, I'm sensitive to the counterargument. This is a likely outcome.

How about 50? It's less likely, but more desirable in my view. It wouldn't drastically undercut the market. This was the expected outcome for all but the last couple days. It would probably contain the fall of the dollar (somewhat) and signal that the Fed expects a more stable environment going forward. I would applaud this choice.

How about 25? A bit risky from the Fed's point of view, I think. It would undercut the market more than is necessary on this given day. I'm sympathetic to the hawks, but given the totality of the situation, 50 is probably the better choice.

Going to be a fun day of class tomorrow! Until then...

I couldn't resist watching a little CNBC tonight. Kudlow was talking about how the Fed should have opened the discount window up to investment banks sooner. After all, Glass-Stegall was repealed in 1999. Since then, the role of investment banks in the financial system has expanded, and they have become intertwined with commercial banks (i.e. depository institutions). But all this time, houses like Bear Stearns have been working without a net. They've been unable to tap the discount window.

So the Kudlows of the world would like to have seen the Fed open the discount window to investment banks sooner. That way, maybe they could have survived this crisis. Hmm... maybe... maybe not. It might have prolonged the agony and the result would have looked more like Continental Illinois which although it came to a head in a day, took weeks for the FDIC to finally take the assets. All the while, they had access to the window and to a number of other banks (who were presumably willing to lend to CI because it had access to the window) to help them liquidate. In terms of restoring confidence to the system, it was probably better this way. Here's the deal. Take it or leave it. They had no choice but to take it.

If it turns out that there is another Bear Stearns out there waiting to happen, you can bet that it will unfold differently now that investment banks have access to the discount window. Should this change be made permanent? Should investment banks have access to the discount window at all times?

That's a tougher question. First, look at the way the Fed's announcement actually reads. They aren't lending directly to the investment banks... they are going through the primary dealers. (It happens that Bear Stearns was a primary dealer so in that case it would have been direct, but it would not necessarily be so in every case.)

First, the Federal Reserve Board voted unanimously to authorize the Federal Reserve Bank of New York to create a lending facility to improve the ability of primary dealers to provide financing to participants in securitization markets.... Credit extended to primary dealers under this facility may be collateralized by a broad range of investment-grade debt securities.

The fact of the matter is that now that this is out there it will be tough to put the genie back in the bottle. It's definitely a good idea in times of crisis. It is probably also a good thing to have on the books so that you don't get caught off-guard in the future. I would only amend it so that the credit is available at a penalty rate. Read Bagehot for the reason why.

Is it necessary to open the window directly to investment banks who are not primary dealers? No, and probably not a good idea either--except as already provided under statute in exigent circumstances. Let's see how this works, and if it works, just keep it on the books as it was announced yesterday.

Now let's look at the other end of the spectrum. For each person like Kudlow who would want to open the discount window to investment banks directly, there is probably a person who would want to reinstate Glass-Stegall and put the wall of separation between investment banks and commercial banks back up again.

But I don't see that as being the problem.

Glass-Stegall was meant to keep the commercial banks from engaging in speculative investment activities that would put customer deposits at risk. That's not what happened here, nor is it likely to be a big issue. The problem is that investment banks dependent on short term repos for daily financing are now as critical (if not more critical) for the stability of the system than the commercial banks of old. They also seem to be as prone (if not more prone) to the kinds of lapses in judgment that led to what we saw this weekend. But walling them off, even if it were realistic to do so now, would not make them go away, get smaller, or suddenly get better judgment.

So how do you get them to behave? Act as their lender of last resort? Lots of moral hazard, not enough moral authority. But perhaps by allowing their peers (here I am referring to the primary dealers) to be their lender (or buyer) of last resort you enforce a kind of market discipline that the Fed alone would have trouble enforcing. Was Bear Stearns a sacrificial lamb on this altar, as many are suggesting? Perhaps. And although I cannot do anything other than speculate as to whether that was the intent, it certainly was the way it worked out. It's too late to do anything about that now, and perhaps it was too late even last week. We'll never know.

But now that a mechanism is in place, I would simply prefer that next time it be done by lending to them at a penalty rate instead of buying at a discount.

Welcome to listeners of Ed Morrissey's show on BlogTalkRadio. I had the honor of visiting with Ed on the air today about the Fed and Bear Stearns. Thanks for dropping by.

...about the Fed's role in the buyout of Bear Stearns by JPMorgan, let it be this article by Greg Ip in the Wall Street Journal. An excerpt:

In some ways, the initiatives better equip the Fed to help a financial system that has changed drastically from one based on banks for most of its 95-year existence. It took a unanimous vote by the Fed's five governors yesterday to invoke a Depression-era clause in the Federal Reserve Act to waive the usual prohibition on Fed loans to nonbanks. A Fed official told reporters today's circumstances couldn't have been envisioned when the Fed was created, and noted newer central banks like Europe's have many of these powers. But these steps also take the central bank into uncharted territory with new and potentially troublesome risks.

Those risks include the possibility that with the credit crunch showing no sign of lifting, the Fed will be called on to lend to other troubled firms and end up a major creditor of Wall Street, even if at present the risk of any substantial loss appears small. Another risk is that while the Fed used a loophole yesterday in the Federal Reserve Act to expand its lending to nonbanks in "unusual and exigent" circumstances, it has in effect expanded the federal safety net with no political debate. However, the Fed sought and received agreement over the $30 billion loan from Treasury Secretary Henry Paulson, who informed President Bush.

Also check out the Real Time Economics Blog.

Some assorted links that didn't make their way into my previous three posts on tonight's events.

Felix Salmon is optimistic about the effect of the sale of Bear Stearns on the financial markets.

John Jansen has some comments and links on the overnight happenings.

The WSJ Real Time Economics Blog has an absolutely excellent post. Choice quotes:

Fed officials went out of their way to say Bear Stearns was unique in the problems it faced. No other major securities firms are in a similar situation, an official said.

and...

So how much has the financial system changed? Consider securities repo, an essential grease that enables dealers to make markets in a wide variety of credit instruments. In 1990, securities repo credit, at $372 billion was about 13% the size of federally insured bank deposits, at $2.8 trillion.

By last year, securities repo credit had ballooned to $2.6 trillion, 60% of the value of federally insured deposits at $4.3 trillion.

Gross repo among the primary dealers alone (that is, excluding banks but including loans among dealers) was $4.5 trillion on March 5, according to the New York Fed.

How secure is that funding base? Well, consider that two-thirds of repo loans mature or must be rolled over each day. And there is no government guarantee behind them (although Treasurys often collateralize them.) No wonder the Fed worried about a run on the repo market if Bear failed.

They also link to this article from 1992 by Anna Schwartz on "The Misuse of the Fed's Discount Window." That brought back memories for me. The article was required reading in my Money and Banking class back in college.

Calculated Risk links to CBOT Dow Futures. Look out below.

I could paraphrase Paul Krugman thusly: You ain't seen nothin' yet.

Reuters reports that Bear Stearns executives won't be getting any golden parachutes. Good.

Tim Duy expects a big fed funds move (75 or 100 basis points) on Tuesday and worries about a destabilizing fall of the dollar. He uses the word "monetization." Let's hope it doesn't come to that. Check back with me on Tuesday.

This is part three in a series of posts relating to this weekend's sale of Bear Stearns to JPMorgan and the Fed's role in the matter. (First post, second post)

The previous post highlighted a few of the reasons that some will be cynical about what happened tonight. The cynics make some relevant points. Moral hazard is a concern. Some will say that the Fed's role in backing JPMorgan is troubling. Similar points were made during the LTCM debacle. And yes, there might be other episodes like this. All true, and yet....

When I take my students up to Chicago to tour places like the Chicago Fed and the Board of Trade, I make sure to give them a little history lesson. At the corner of Jackson and LaSalle stands a reminder of another financial crisis with particular relevance to today--the old Continental Illinois building. Bank of America now occupies the space, but the name remains carved in stone as a mute testimony to what once was. The name faces out over LaSalle St. directly across from the main entrance to the Chicago Fed building. I have often thought, as I enter the Fed building, that having that name as a constant presence across the street must give anyone who works at the bank a sense of purpose. The Fed's very existence (and that of other regulators) is meant to prevent such bank failures and when prevention fails, to cushion the greater economy from the effects.

To be sure, there are some similarities as well as many striking differences between the Bear Stearns situation and that of Continental Illinois over twenty years ago. Continental Illinois was a commercial bank. Deposits were at risk. In that way, it was quite different from the situation we see today.

Despite these differences, one similarity between Continental Illinois and Bear Stearns is that they will both go down in the history books as a milestone in the Fed's evolution as a lender of last resort. For a great recounting of the Continental Illinois collapse, check out this document on the FDIC website: "History of the Eighties--Lessons for the Future." In particular, look at chapter 7, which details how the events unfolded and what was learned. This passage from page 249 is the appropriate text for today.

As has been noted, however, [Too Big To Fail] was an inaccurate term: “too big to liquidate” would have been more appropriate. Large banks did fail during the period, with shareholders losing their investments and managements being removed. In significant ways, Continental “failed.” But as one regulator observed, the banking agencies were “reluctant to tolerate the sudden and uncontrolled failure of large institutions and therefore generally opt[ed] for managed shrinkage, merger, or recapitalization.” There were several reasons for adopting such an attitude, the most important of which was “systemic risk.” This rubric covered “potential spillover effects leading to widespread depositor runs, impairment of public confidence in the broader financial system, or serious disruptions in domestic and international payment and settlement systems. In addition to systemic risk, the logistical difficulties and potential expense of liquidating a large bank also contributed to regulatory reluctance to close such a bank and pay off insured depositors. Moreover, liquidation would mean tying up uninsured depositors’ funds during the lengthy proceedings, a situation that could have a very disruptive effect on a bank’s community. For all these reasons combined, the larger the bank, the more likely it was that bank regulators would look for alternatives to closing the bank and paying off the insured depositors.

Except for the part about depositors, it could have been written about this weekend. Indeed, Bear Stearns failed. But it proved too big to liquidate without assistance. Continental Illinois essentially did go into receivership. The FDIC guaranteed everything, even beyond the $100,000/deposit limit. The Fed provided the backstop liquidity. It was not without controversy. And it took months to come to a head, and months to finally work out.

How things have changed. When this story first broke, the NY Times reported:

The developments may only postpone the eventual sale of all or part of Bear Stearns, which has had crippling losses on mortgage-linked investments. To keep the 85-year-old firm solvent, JPMorgan, backed by the New York Fed, extended a secured line of credit that gives Bear Stearns at least 28 days to shore up its finances or, more likely, to find a buyer.

One day, folks. One day and the deal was done. Would the markets have gone into a tailspin if it didn't get done that fast? Hard to say. What is not hard to say is that no one wanted to take that chance. You know that everyone involved at the Fed knows that they are doing something that will be scrutinized and criticized. They know about the moral hazard problem. They know that this could have negative consequences. They know that there is only one reason to do it--and that is that the consequences of not doing it are potentially much worse. Mr. Bernanke, scholar of the Great Depression, knows that better than most.

By pulling out all the stops the way that he has, Mr. Bernanke is probably already the most innovative Fed chair in history. I'm sure he would rather not have that distinction, but there are worse ways to distinguish oneself. And so in the final analysis (at least for tonight) I have to applaud Mr. Bernanke and the Fed for taking the steps to allow for an orderly liquidation of a failed institution--a very different thing from a bailout (Ritholtz agrees). JPMorgan can probably liquidate the assets more efficiently than the government could in a short amount of time. With the way that financial markets are connected and positions are so heavily leveraged they could not afford to shop Bear Stearns around the way that they did Continental Illinois. If we are to believe what we're hearing, the wheels were about to come off. The "repo" market moves too quickly and is less forgiving than a depositor in a commercial bank. Undoubtedly banks and other institutions had loaned Bear Stearns large amounts in the repo market and if they didn't get paid, well, that would indeed be the sort of thing that causes the whole market to seize up very suddenly, perhaps catastrophically. Not a slow motion deposit-driven meltdown.

Kind of makes Continental Illinois look like a minor hiccup in comparison. And yet here we are twenty-some years later talking about that event--its aftermath coloring our perception of today's events.

The Fed was presented with a tough choice and probably made a good call. And while some of the critics objections are reasoned (Buiter), some just don't get it. Today's public flogging of the MSM is outsourced to Brad DeLong.

As Buce of Underbelly puts it, Gretchen Morgenson fails to understand the distinction between preserving the lines of business that are the enterprise and rescuing the holders of the equity in the firm:

Rescue Me: A Fed Bailout Crosses a Line: WHAT are the consequences of a world in which regulators rescue even the financial institutions whose recklessness and greed helped create the titanic credit mess we are in? Will the consequences be an even weaker currency, rampant inflation, a continuation of the slow bleed that we have witnessed at banks and brokerage firms for the past year?

Or all of the above?

Stick around, because we'll soon find out. And it's not going to be pretty.

Agreeing to guarantee a 28-day credit line to Bear Stearns, by way of JPMorgan Chase, the Federal Reserve Bank of New York conceded last Friday that no sizable firm with a book of mortgage securities or loans out to mortgage issuers could be allowed to fail right now.... But why save Bear Stearns? The beneficiary of this bailout, remember, has often operated in the gray areas of Wall Street and with an aggressive, brass-knuckles approach.... Let's not forget that Bear Stearns lost billions for its clients last summer, when two hedge funds investing heavily in mortgage securities collapsed. And the firm tried to dump toxic mortgage securities it held in its own vaults onto the public last summer in an initial public offering of a financial company called Everquest Financial. Thankfully, that deal never got done.... And so, Bear Stearns, a firm that some say is this decade's version of Drexel Burnham Lambert, the anything-goes, 1980s junk-bond shop dominated by Michael Milken, is rescued. Almost two decades ago, Drexel was left to die...

It does not seem that she gets it.

I have to agree with DeLong. This is far a desirable outcome, but the consequences of inaction were worse. I admit to being uncomfortable with the Fed as a backstop and I worry about the precedent this sets. Tell me who is comfortable with it? It should make one very uncomfortable, and I'm sure that a lot of folks at the Fed are not sleeping well tonight. But sometimes you need to make the uncomfortable choice.

And so now we'll just have to wait and see how much the new lending facility gets used.

I didn't even get to talking about the discount rate. In light of everything else going on, it's a minor part of the story, and the fact that they lowered it is maybe a little bit of overkill. If someone can explain why an extra quarter point today as opposed to Tuesday is going to help the liquidity issues, I'm all ears.

This post continues the discussion from here. The immediate question is, of course, whether the Fed's facilitation of JPMorgan's rescue of Bear Stearns was a good idea. Here is a "no" vote from Willem Buiter (via Felix Salmon)

The Federal Reserve Act (1913) allows the Federal Reserve to lend, in a crisis, to just about any institution, organisation or individual, and against any collateral the Fed deems fit. Specifically, if the Board of Governors of the Federal Reserve System determines that there are “unusual and exigent circumstances” and at least five (out of seven) governors vote to authorize lending under Section 13(3) of the Federal Reserve Act, the Federal Reserve can discount for individuals, partnerships and corporations (IPCs) “notes, drafts and bills of exchange indorsed or otherwise secured to the satisfaction of the Federal Reserve bank…”.

The combination of the restriction of “unusual and exigent circumstances” and the further restriction that the Federal Reserve can discount only to IPCs “unable to secure adequate credit accommodations from other banking institutions”, fits the description of a credit crunch/liquidity crisis like a glove. So why hasn’t the Fed declared “unusual and exigent circumstances” yet, so non-deposit-taking financial and other institutions in need of liquidity and blessed with eligible collateral can go directly to the discount window? When in doubt, leave the middleman out.

...

Since Bear Stearns is not a deposit-taking institution, and appears to be of no other systemic significance, there is no need for a special resolution regime of the kind managed by the FDIC for troubled deposit-taking institutions. The firm could have been left to go into receivership.

If the Fed fears the risk of contagion effects and financial panic, it could have requested the nationalisation of the investment bank. This should have been done at a zero price. The existing shareholders could, if the US government were feeling generous, be granted the privilige of claim on whatever value is left after all other creditors have been paid off.

But the shareholders of Bear Stearns are eating their cake and having it. Shares may have dropped 43 percent in value, but what is left still beats nothing. And nothing seems the only possible fair value for what Bear Stearns would be worth without Fed assistance. Why was Bear Stearns not taken into public ownership, preferably at a zero price?

One would hope that, as soon as the rescue was announced, the existing management and board of Bear Stearns would have resigned en-masse, and without any golden handshakes of the CEO of Citigroup and Merrill Lynch -variety. This should have been a condition of the loan being made. The argument that only the existing management understands the business well enough to see it through the storm is unconvincing, as these are the very people that screwed it up in the first place. Why are the old top management and board members still in their jobs?

Another key issue concerns the terms on which Bear Stearns now borrows. I have always considered the Fed’s decision to lower the spread between the discount rate and the Federal Funds target rate to be a mistake - an inframarginal subsidy to those lucky enough to have access to the facility. Now we see why. If Bear Stearns can borrow at 50 bps over the 28-day OIS rate, or anything in that ballpark, it would be scandal.

Good points. And the first of those points (unusual and exigent circumstances) is what tonight's announcement by the Fed addresses--in a new and innovative way. From the press release,

First, the Federal Reserve Board voted unanimously to authorize the Federal Reserve Bank of New York to create a lending facility to improve the ability of primary dealers to provide financing to participants in securitization markets. This facility will be available for business on Monday, March 17. It will be in place for at least six months and may be extended as conditions warrant. Credit extended to primary dealers under this facility may be collateralized by a broad range of investment-grade debt securities. The interest rate charged on such credit will be the same as the primary credit rate, or discount rate, at the Federal Reserve Bank of New York.

So there it is. A new lending facility which appears to be inspired by the spirit of the "unusual and exigent circumstances" clause to which Buiter refers. But as path-breaking as this is, it is not quite as drastic as if the Fed had invoked that phrase and opened the door even wider. It is limited to primary dealers, which are listed here. These are the institutions that the New York Fed works with on a daily basis in the conduct of open market operations. One could argue that the Fed already uses them as a conduit for routine monetary policy, so they are the natural choice for facilitating these emergency actions.

If they are simply acting as a conduit for loans, that would be odd--sort of a regulatory quirk reflecting a holdover of the post-Depression wall that has now fallen between deposit institutions and investment institutions. It's a patch rather than a permanent fix while we try to figure out how to keep this from happening again and how to address it more effectively if it does. Not what I would suggest if I were designing the system de novo, but an understandable thing to do in the heat of battle.

But if it leads to the primary dealers swallowing up troubled institutions, then it does raise some issues of the sort that Buiter outlines in the second part of the quote. Why not take Bear Stearns (and whoever may be next in line) into public receivership directly?

Such questions are all the more relevant tonight as news comes of the sale of Bear Stearns to JPMorgan for $2 a share.

Reflecting Bear Stearns’s dire straits, JPMorgan agreed to pay just $236 million for the firm, a figure that includes the price of Bear’s soaring headquarters on Madison Avenue in Manhattan. At $2 a share, JPMorgan is buying Bear Stearns for a third of the price at which the troubled firm went public in 1985. Only a year ago, Bear’s shares fetched $170. The cut-rate price reflects deep misgivings about the firm’s prospects.

JPMorgan said it was guaranteeing the trading obligations of Bear Stearns and its subsidiaries, effective immediately. “JPMorgan Chase stands behind Bear Stearns,” Jamie Dimon, JPMorgan’s chief executive, said in a statement. “Bear Stearns’s clients and counterparties should feel secure that JPMorgan is guaranteeing Bear Stearns’s counterparty risk.”

The companies said that the Federal Reserve would provide special financing in connection with the transaction and that the Fed had agreed to fund up to $30 billion of Bear Stearns’s “less-liquid assets.”

If you're a fan of the movie It's a Wonderful Life, this is where George Bailey says "Potter's not selling. Potter's buying!" I mean, the Bear Stearns building alone must be worth....

But it's the last paragraph I quoted that leads to headlines like this, from a blog on the L.A. Times: "With Fed financing, JP Morgan buys Bear Stearns".

I suspect that's not how Mr. Bernanke wants this to be viewed.

But the cynic who has moral hazard on his mind can't help but ask... If they do it once like this, what if it happens again? What if another entity considered too big to fail gets special financing from one of the primary dealers through this new facility? As we saw tonight, it is but a small step from a loan guarantee to a fire sale.

This is a good time to link to Brad DeLong's excellent post in which he tells us what Bernanke, Paulson, et al. should have done this weekend. He would have the Treasury set a (discounted) price for mortgages that look a little shaky, buy them, push the market back to equilibrium, and make money for the taxpayer in the process.

If I were working for the Treasury right now, I would be saying: make this happen on Monday. There isn't time to set up a new bureaucrtacy--a HOLC, which is what Alan Blinder wanted to do as of three weeks ago. So use an existing bureaucracy: Fannie Mae. If I were Treasury Secretary Hank Paulson, I would spend the weekend building a legislative vehicle to introduce Monday morning on an emergency basis to give Fannie Mae the resources and the mission to undertake this mortgage rescue operation, and I think Fannie Mae is the right institution for the task: why does it have its government-sponsored status and guarantee if not to be used for purposes like these at times like these?

And if I were Ben Bernanke and Tim Geithner, I would be spending this weekend thinking about how to first thing Monday morning punish bear speculators on Bear Stearns, Lehman, and others by pushing their CDS spreads back to more normal levels. It seems to me that people on Wall Street need to be taught that betting that the Fed will not intervene to stabilize or that its interventions to stabilize will be unsuccessful is an unhealthy thing to do.

The Bear Stearns sale notwithstanding, it's not too late to do something approximating DeLong's (and Blinder's) suggestions to head off future episodes. (Who thinks that this is the end?)

Whether $2 a share is sufficient punishment for the speculators is left to the reader.

Some closing thoughts (at least for tonight) in the next post.

I do not know the answer to my title question, but if anyone does, I am curious. Anyway, here is the announcement from the Fed, and this is the first in what will be at least two posts on the subject by me tonight. If it were just one post, it would be far too long. So let's get started.

This story starts as a bank run... not like the one in It's a Wonderful Life, but a run on an investment bank. Less of a public spectacle, but just as nerve-wracking. (NY Times)

Just three days ago, the head of Bear Stearns, the beleaguered investment bank, sought to assure Wall Street that his firm was safe.

But those assurances were blown away in what amounted to a bank run at Bear Stearns, prompting JPMorgan Chase and the Federal Reserve Bank of New York to step in on Friday with a financial rescue package intended to keep the firm afloat.

...

The developments may only postpone the eventual sale of all or part of Bear Stearns, which has had crippling losses on mortgage-linked investments. To keep the 85-year-old firm solvent, JPMorgan, backed by the New York Fed, extended a secured line of credit that gives Bear Stearns at least 28 days to shore up its finances or, more likely, to find a buyer.

Comment #1: This article is from yesterday--March 15. The sale of Bear Stearns will probably be consummated tonight. That is an indication of just how quickly these things are moving. So quickly that the financial reporters who spend their days enmeshed in these stories are underestimating how rapidly the events will unfold.

News of the bailout ignited fears that other big banks remain vulnerable to the continuing credit crisis, and stocks tumbled in another rocky day for the markets. Financial shares led the way, with shares of Bear Stearns plunging 47 percent. Hours after the rescue was announced, another Wall Street firm, Lehman Brothers, said it had secured a three-year credit line from banks. Its stock fell 15 percent.

Comment #2: Counterparty risk and systemic risk--look them up.

The Fed’s intervention highlights the problems regulators face as they contemplate the prospect that investment banks, saddled with toxic securities tied to subprime mortgages, are losing the trust of their lenders and clients — the kiss of death on Wall Street, where confidence has always been the most precious asset of all.

Traditionally regulators have helped commercial banks in financial panics, but not investment banks, which do not hold customer deposits. But the 1999 repeal of the Glass-Steagall Act, the Depression-era law that separated investment banks and commercial banks, led to consolidation within the financial industry that has made such distinctions harder to make.

“I don’t remember a Fed action aimed at a noncommercial bank; this is the kind of thing you see in this post-regulatory environment,” said Charles Geisst, a Wall Street historian at Manhattan College.

Comment #3: Indeed this is a sign of our times. The consequences of investment bank versus commercial bank failure are different and so are the reasons for rescuing them. In the movie It's a Wonderful Life, when the Bailey Building and Loan faces a bank run, the deposits of the townspeople (the "little guys", if you will) are directly at risk. But when Bear Stearns cannot meet its obligations to its creditors (who are anything but "little guys"), it means that those creditors may face difficulty in meeting their obligations. Eventually, as the crisis deepens, it will begin to threaten commercial banks that do have more of a connection to "real people" with deposits that FDIC will make sure are protected. Certainly that is the worst-case scenario that everyone wants to avoid.

So did the Fed do the right thing by intervening? There are many reasons to say yes, but not everyone thinks so. This post is getting long, and a full answer to this question deserves it's own. To be continued...

UPDATE: John Jansen informs us that October 6, 1979 was a Saturday. Close enough. Students of monetary policy need only read the date to know what that was about.

I'm in the middle of a few things that are keeping me from blogging an extended analysis of the Fed's recent actions. But I did come across something today that will interest my readers. The WSJ Real Time Economics Blog opens a post with this:

Back in 2003, when the Federal Reserve cut interest rates to 1%, the world worried that the Fed was running out of ammunition and would soon have to turn to unconventional tools.

Now, in 2008, it’s worth asking if the Fed could run out of unconventional ammunition. Tuesday’s offer to lend $200 billion of its Treasury holdings to primary dealers in return for mortgage-backed securities both guaranteed by the government-sponsored enterprises (Fannie Mae and Freddie Mac) and not (private-label MBS) means it will have eventually sold or pledged half of its Treasurys, limiting how many more of these tricks it can pull off.

My first thought when I heard about this innovative move the Fed was that it would take the pressure off for a few days--maybe a week or two. And what then?

Here's a link to the new PDF version of the Beige Book. Here's the old html version.

The Wall Street Journal headline is "Beige Book Hints at Stagflation Amid Slow Growth, Prices Pressures"

I'm heading out the door, but I know what I'll be reading tonight.

... is from the Wall Street Journal's Greg Ip. In today's piece, "For the Fed, a Recession -- Not Inflation -- Poses Greater Threat", he writes:

So why is the Fed more worried about growth than inflation? First, it thinks run-ups in commodity prices explain the increases, not only in overall inflation but also in core inflation: higher energy costs have "passed through" to other goods and services. Core inflation rose and fell with energy inflation between early 2006 and mid-2007, and the Fed thinks the same thing is probably happening now. If energy and food prices stop rising -- they don't have to actually fall -- both overall and core inflation should recede.

...

For the current high inflation rates to become permanent, the Fed believes it has to become embedded in how workers and businesses set wages and prices. So far, surveys suggest consumers haven't raised their expectations of inflation much. In last year's fourth quarter, hourly wages and benefits were up just 3% from a year earlier, a slowdown from 2006, even though unemployment was below 5% for almost all that period. A wage-price spiral requires wages to cooperate.

Wages are even less likely to accelerate if unemployment, now 4.9%, rises to 5.25% this year and falls only gradually to 5% by 2010, as the Fed's Federal Open Market Committee forecasts. That implies three years with the unemployment rate above the FOMC's estimated "natural" rate of about 4.9%, and thus steady downward pressure on inflation.

The notion that higher unemployment reduces inflation has its skeptics, even at the Fed. "All you have to do is recall the 1970s, when we experienced both high unemployment and high inflation, to appreciate that slow economic growth and lower inflation don't necessarily go hand in hand," Federal Reserve Bank of Philadelphia President Charles Plosser said last month.

I must say that I get a little nervous about pinning my hopes for inflation reduction on a forecast that unemployment will be a couple tenths of a percent over the supposed "natural" rate. Even if you believe in some kind of an expectations augmented Phillips curve, you have to wonder about what has been happening in recent weeks. The genie may not be out of the bottle yet, but it's beginning to look like someone popped the cork.

Ip continues,

Critics say the Fed also took too long to reverse the ultralow rates of 2001-2003, thereby fueling the housing bubble -- if not rampant inflation -- whose collapse now threatens the economy. Federal Reserve Bank of St. Louis President William Poole became one of the first people who participated in that decision to repudiate it. "With the benefit of hindsight...it is not hard to argue that the [Fed] was too slow to raise the federal-funds target after taking the target down to 1% in 2003," he said at a conference on Friday.

Even Fed officials who don't share that view agree that both that episode and the 1970s experience argue for promptly reversing rate cuts once the current crisis passes.

That's easier said than done. The Fed is unlikely to face an outlook so unambiguously positive anytime soon that such a reversal will be a slam-dunk, and during an election year, it will face intense political pressure not to raise rates.

Whether the Fed reverses course "on an appropriate schedule" will be clear in five years or so, Mr. Poole said.

This is not the first place I've seen this sentiment (of rate hikes as soon as this crisis passes) expressed recently. That makes me think that there is a concerted effort to manage expectations here. At this point, I'd say the most likely time for the Fed to want to begin tightening again (barring any unforeseen developments) will probably be very close to election time. It will be a tough sell. Better start paving the way soon.

And Poole's final comment is very much on the money.

The news isn't good. The PPI is on the rise. (MSNBC)

WASHINGTON - Battered by bad economic news, consumer confidence plunged while wholesale food, energy and medicine costs soared, pushing inflation up at the fastest pace in a quarter century.

The Labor Department said Tuesday that wholesale inflation jumped by 1 percent in January, more than double the increase that analysts had been expecting.

The next paragraph isn't about inflation, but isn't great either...

Meanwhile, the New York-based Conference Board reported that its confidence index fell to 75.0 in February, down from a revised January reading of 87.3. The drop was far below the 83 reading that analysts had forecast and put the index at its lowest level since February 2003, a period that reflected anxiety in the lead up to the Iraq war.

And on another note, I was revising my homework solutions for my principles of macro course this semester. I always ask students to find the most recent rate of inflation by the CPI (12 month % change). Last semester, the answer was 2.0% at the time I asked the question. The answer now? 4.4%. (4.3% not seasonally adjusted)

Uh oh.

But Martin Feldstein does say this in Wednesday's Wall St. Journal:

The dysfunctional character of the credit markets means that a Fed policy of reducing interest rates cannot be as effective in stimulating the economy as it has been in the past. Monetary policy may simply lack traction in the current credit environment.

As they say, read the whole thing.

Yesterday, I pointed to comments by William Poole. There were also similar remarks from Janet Yellen and Charles Plosser. Both remain concerned about inflation, with Plosser appearing to be more skeptical of the anticipated moderation of inflation coming this year. (Hat tip to Greg Mankiw for the links.)

In contrast, the Philly Fed is concerned. So are many economists on Wall St.

But then we have this interesting piece from King Banaian (SCSU Scholars). He quotes from this article in his local paper. The article raises the following question in my mind: Are American households really worried about a traditional recession or are they concerned about changing relative prices causing them to adjust their expenditures? Before you dismiss the question, take a look... this could be any newspaper in any city.

Cindy Haupert's life has changed since the economy took a dive.

Haupert, 36, once lived comfortably with her husband and two children in St. Cloud. She was a stay-at-home mom, working every other weekend. Her husband is an attorney. They made ends meet.

But gas prices would rise. Costs for homemade dinners and lunches would increase. And in September, when it was time for her son to go to kindergarten, she wanted him to go all-day, every day, so he could be ready for first grade. But that meant a $184 hit to the family checkbook each month. That doesn't even count lunch money.

"Now it's like we're living paycheck to paycheck. I can definitely see a change," she said.

Prices rising faster than wages Lifestyle changes. There's nothing so far about a real recession in the classical sense. As King points out, she didn't have to pay for all-day kindergarten. The writers says this all happened since the economy "took a dive"? Did their income fall? That question is not addressed.

But the writer understands that cost of living increases is just inflation by another name...

The consumer price index for Midwestern states, including Minnesota, increased 3.8 percent from December 2006 to December 2007. That reflects the increased cost of living.

So what's a person to do?

Haupert feels it. She now works an additional four days a week at Office Depot as a cashier while her fifth-grader and kindergartner are in school.

Wait... what? She's increasing her hours worked? Isn't that contrary to what happens in a traditional recession? Sure, we shouldn't generalize from one person's experience. But this is what the newspaper is giving us, and I don't think this is the only story of its kind in the media. Is the new face of "recession" someone who has to work harder to maintain their standard of living with higher gas prices, etc.?

She tries to make up for extra costs. She clips coupons and budgets meticulously. She's allowed herself and her husband $90 per week for gas and $125 per week for groceries.

She takes advantage of mail-in rebates and uses gas coupons. She rides the bus when she can and doesn't take frivolous drives.

When she and her husband bought a new TV to accommodate the high-definition requirement for 2009, they shopped around. They checked prices to see where they could get the best deal.

When they settled on one with a better warranty, they got an extra 10 percent off for comparing prices.

Again I ask, is shopping around to get an extra 10% off an HDTV a sign of a weak economy or a smart consumer facing different relative prices?

(By the way, if they have cable or satellite, they don't need a new TV in 2009, at least not right away.)

I don't mean to diminish the cases where people have lost their jobs due to slack demand in construction or manufacturing, etc. There are certainly people who are feeling the effects of the slowing economy. And while those people may be larger in number today than, say, a year ago, they still represent a fairly small slice of the population.

Yet, so many people surveyed by the major media have a profoundly dismal view of the economy--even if they are not unemployed or particularly at great risk of becoming unemployed. And I am seeing more and more anecdotal stories like this one where what people are really concerned about boils down to the increasing cost of living (inflation) and the choices that one has to make to cope with the increased cost. Gas prices are higher. Real incomes have not increased as rapidly. Thus, one will need to cut back on gas or cut back on something else. If that means shopping around for the best deal on an HDTV or getting one that is a couple inches smaller, then that's just the way it is.

We are now experiencing somewhat slower and more uneven growth of real income than at other times in our history. The current inflation we are experiencing is also uneven in the sense that some prices are rising faster than others. Some prices (like HDTVs) are even falling. And that does create some distortions. But there's little that the Fed can do to reverse the long trend of slower wage growth. That is largely a structural problem that transcends the current recession or non-recession. There's little that the Fed or congress can do to address changes in relative prices which are the real source of dissatisfaction with the economy for so many people.

So at the end of the day, I'm not sure what to make of this. Is this just a bad article and a bad interview subject for the point the writer was trying to make? Or is this indicative of the reasons behind the dissatisfaction with the economy for a significant number of people? If the former, then this post is a cautionary tale for journalists and we can perhaps leave it at that. But if the latter, then we really need to have a talk about the difference between a real recession and other economic events that can also cause households some distress such as changing relative prices that are not necessarily recessionary.

Outgoing St. Louis Fed president William Poole gave a speech to the St. Louis NABE today. I linked to the Reuters story in the previous post. Now, I would like to post some excerpts from the speech that didn't make the wires. Most of the speech has to do with central bank communications.

My general approach has been to speak primarily about the policy process rather than the specific situation facing the FOMC at its next meeting. I try to think of myself as speaking to portfolio managers who have a medium-term horizon rather than to traders who have a horizon measured in hours or a few days. I do not disparage traders—they perform an important function. Obviously, I have had internal information that would be of interest to traders but it would be entirely inappropriate—indeed illegal—to disclose confidential FOMC information.

Traders, portfolio managers and many others always want to know my forecast of what will happen at the upcoming FOMC meeting. My standard answer is that I do not forecast monetary policy decisions—my job is to participate in making those decisions. I confess that, initially, this response was something of a dodge, because I usually had a pretty good idea weeks in advance of what my own position at a meeting would be. However, over the years I have become impressed by how often my own position would change even in the days just before a meeting as a consequence of the arrival of new information, including staff analysis and sound arguments by my FOMC colleagues. It is not that my views are pushed this way and that by arrival of the latest economic data reports. What happens is that, from time to time, compelling new information does arrive. I hope that my policy outlook was stable even as my view on the appropriate policy action might change in the light of incoming data.

Thinking through the matter led me to a bit of research. Working with Bob Rasche, the St. Louis Fed research director, I had already studied the accuracy of market expectations about FOMC decisions using data from the federal funds futures market the day before each FOMC meeting. Given that those futures market forecasts have proven to be quite accurate, an obvious question was forecast accuracy longer in advance. Bob and I studied futures market predictions of the fed funds rate three and six months in advance and found that the accuracy was pretty low. The reason these forecasts have not been very good is that new information arrives that calls for a changed expectation on the monetary policy setting, both for the markets and for the FOMC. I not only became more aware of the need for me to keep my mind open but also thought it important to explain to my audiences how the policy process worked to be responsive to new information.

...

I also became troubled by the following argument. If current economic conditions were such to suggest a high probability that future economic conditions would justify a future increase in the funds rate target, why not just raise the rate at the current meeting? Given lags in the effects of policy actions, the current policy had to be based on the future outlook. On the other hand, if the probability were low, would it serve the cause of good communication to state a bias? Wouldn’t it be more helpful to work harder to articulate the conditions under which the committee might change the target—to explain in more detail the nature of the policy rule or response function?

Another problem with forward policy guidance was that a slow accumulation of information sometimes made the prior balance-of-risks language out of date, but it was not easy to take it out of the statement without sending a message, or seeming to, that a future policy adjustment in the other direction was contemplated. This problem arose in 2006. In August 2006, the committee kept the funds rate target unchanged, after increasing it by 25 basis points at each of its previous 17 meetings. However, the statement indicated a bias toward a further increase by saying this: “Nonetheless, the Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.” Just ahead of the August meeting, the market had assigned a probability of about 0.8 on an FOMC target fed funds rate of 5.25 percent and a probability of about 0.2 on a target rate of 5.5 percent.

Just after the August 2006 FOMC meeting, the market assigned these probabilities to the FOMC decision at its forthcoming September meeting: a target of 5.25 percent had a probability of about 0.78, a target of 5.5 percent had a probability of about 0.2 percent, and a target of 5.75 percent had a probability of about 0.02 percent. Although the FOMC retained the language that “firming may be needed” at subsequent meetings, over time the market lowered its probability that the FOMC would in fact raise the target rate. Ahead of the FOMC meeting of Jan. 30-31, 2007 the market placed essentially zero probability on any target rate above the prevailing rate of 5.25 percent.

At its meeting of March 20-21, 2007, the committee dropped the language referring to possible firming. Doing so made little difference given that the market had discounted the possibility of firming for some time.

Here's the key paragraph of the whole thing...

I have recounted several of these episodes in some detail to illustrate the general issue. As a consequence of observing this process for 10 years, I have concluded that an FOMC attempt to provide forward guidance in the policy statement causes more communications difficulties than it solves. A key reason is that the economy is subject to more shocks and reversals than one might think. These shocks sometimes require more frequent policy actions than I would have thought likely when I came to St. Louis. At a minimum, changing economic conditions change the likelihood that the FOMC will want to adjust the fed funds target in the direction previously thought. Directional language tends to remain in the FOMC policy statement beyond the time it applies and removing the language creates the possibility of miscommunication. Every change in the policy statement leads naturally to market questions as to what the change means and whether the change is meant to provide a hint about the future direction of policy. To my mind, every time new language is inserted into the policy statement, there needs to be as much thought given as to how to exit from the language as to the rationale for inserting it. (Emphasis mine)

Oh, how true. I blogged about this over two years ago. At the time, I was hopeful that this was a solvable problem. The intervening two years have made me less optimistic--apparently, I'm not alone.

Now, some might be surprised or taken aback by his talk of "hunches" in the next paragraph, but I think most veteran Fed watchers know what he means. I know I do.

I know that market participants are hungry for insight into the FOMC’s thinking and into the likelihood of future adjustments in the target federal funds rate. My judgment is that, most of the time, the committee cannot provide what the market wants because the committee itself is not clairvoyant. No one knows how the economy is going to evolve and how events will change the appropriate setting of the federal funds target rate. Most of the time over the past 10 years I had hunches about the policy direction I would be advocating at the next FOMC meeting, but “hunches” really is the right word. I had hunches and not settled convictions. Furthermore, the more I reflected and the more experience I accumulated, the more I realized how frequently surprise changes in conditions required that I change my hunches. I should not be misinterpreted as saying that I necessarily changed my view on the appropriate setting of the fed funds rate target. But when the information on which my prior hunch was based changed significantly, I had to start over, in a sense, to figure out whether the new information required a change in the policy stance.

This one's going on the reading list.

Lawrence White explains why the gold standard may not be such a bad idea. It's a Cato podcast... with a briefing paper to go along with it.

Tim Duy gets frustrated with people comparing our current problems with Japan in the 1990s. Me too. He also gives his take on Plosser's speech and more.

Jeff Frankel is blogging. Go. Read. Now.

Andrew Samwick is disappointed with congress over the stimulus package.

Michael Mandel thinks so.

Here’s a thought…maybe part of the reason the credit markets are in such bad shape because the Fed raised rates too fast and too high. Think about it—they started raising rates in June, 2004. It was a quarter point increase, from 1 to 1.25. Two years later, the Fed funds rate was up to 5.25. That’s four percentage points in only two years.

...

Basically the Fed took a sledgehammer to the subprime sector in order to slow the economy…they should not be surprised that it broke.

In retrospect it would have been better for the Fed to have stopped at 4% and waited for a while to see what happened. If we assume that it takes 12-18 months for the effect of rate changes to propagate through the economy, they basically showed too much impatience.

I'm not so sure. My main beef during the long, slow rate increase was that they got boxed into a corner with their "measured pace" language. They might have been better off raising the funds rate a little faster at first rather than dragging it out for two years. The measured pace gave the bubbling real estate market more time to ferment into a potent brew. "Sledgehammer" isn't the word I'd use for Greenspan's handling of the situation.

Besides, the teaser rates would have reset anyway, and that's the real problem. Felix Salmon is also skeptical of Mandel's argument.

That's not to say that rates maybe are a little on the high side even now (though the 1.25% shaving last month gets us closer to the sweet spot). In fact, I raised this point tonight at this event with our students. I showed a graph of the Taylor rule and how rates were below what the rule implied in 2003 and recently went a bit above what the rule implied as the economy slows. I'm still a hawk, but even a hawk knows to back down once the tide has turned. Richmond Fed president Lacker would be another case in point. From Reuters:

Lacker said on Tuesday more rate cuts may be necessary to hold off a downturn.

"The prominence of downside risks means that further easing ultimately may be warranted," Lacker said.

However, he added that if economic indicators are not weaker than expected over the next several months, "it's not clear further rate cuts would be warranted."

and...

A well-known inflation hawk, Lacker said persistently high levels of inflation continue to trouble him and limit the Fed's choices in thwarting recession.

"It implies that one doesn't ease as aggressively as one otherwise would," he said.

Well said.

As always, let's lead off with the statement itself. From the Federal Reserve website (which was noticeably slow due to heavy traffic around the time the statement came out):

The Federal Open Market Committee decided today to lower its target for the federal funds rate 50 basis points to 3 percent.

Financial markets remain under considerable stress, and credit has tightened further for some businesses and households. Moreover, recent information indicates a deepening of the housing contraction as well as some softening in labor markets.

The Committee expects inflation to moderate in coming quarters, but it will be necessary to continue to monitor inflation developments carefully.

Today’s policy action, combined with those taken earlier, should help to promote moderate growth over time and to mitigate the risks to economic activity. However, downside risks to growth remain. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risks.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh. Voting against was Richard W. Fisher, who preferred no change in the target for the federal funds rate at this meeting.

In a related action, the Board of Governors unanimously approved a 50-basis-point decrease in the discount rate to 3-1/2 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, Philadelphia, Cleveland, Atlanta, Chicago, St. Louis, Kansas City, and San Francisco.

I expected that if it turned out to be 50 basis points that someone might have preferred 25. To see Fisher vote for no change at all was a moderate (but not a complete) surprise. The lackluster GDP report probably didn't swing the committee one way or the other, but it does give them a little bit of room to say that these significant cuts are warranted in the face of an obviously slowing economy.

Notably there is nothing in this statement to suggest that they are done anytime soon. There is one token reference to inflation that is now almost boilerplate language. They lead off with a statement about "stress" in the financial markets, and I think that choice of word is very appropriate. It is no secret anymore that these measures are meant to head off any possibility that the financial markets would seize up and accelerate the downturn. They are taking the stand that it is more important to mitigate that risk than to doggedly pursue continued inflation reduction. They are betting that when the risk passes that they can remove this accommodation (faster than in '04-'05, I would both hope and expect) with little long term inflationary consequence.

At least it looks like that's the plan. I expect another cut at the next meeting, or possibly between meetings if there is significant "stress" in the financial markets. Size to be determined later. Some call it the "Bernanke put". But the article to which I link explains the nuances:

"It is not the responsibility of the Federal Reserve -- nor would it be appropriate -- to protect lenders and investors from the consequences of their financial decisions," [Bernanke] told a central bank gathering in Jackson Hole, Wyoming.

"But developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy," he added.

The Fed's job is harder these days. In the old days they just worried about walking the tightrope between inflation and recession. Today, that problem still exists, but they must also worry about protecting the broader economy from the consequences of bad decisions in financial markets while still allowing those responsible for the bad decisions to get their comeuppance. In the end, the latter may actually be the more difficult problem.

From the Wall St. Journal Real Time Economics Blog comes this comment from Mark Gertler,

Now why did the Fed have to move on Tuesday — why not wait until the next FOMC meeting? To date, the Fed has done a good job of separating the explicit timing of funds rate cuts from stock price declines (e.g. witness last August). However, given the weakened state of financial institutions, a sharp asset price contraction had the potential to significantly disrupt credit flows and thus do significant harm to the real economy. The Fed action offset this potentially disruptive chain of events. Of course, we can’t do the counterfactual of examining what would have happened had the Fed done nothing (just as we can’t for the intervention last August). But many would agree that a real disaster might have ensued.

Read the whole thing. Gertler has a point. And so here we are at the beginning of a two day FOMC meeting waiting to see if there will be another cut tomorrow and how much it will be. The market seems torn between 25 and 50 basis points. 25 seem the most reasonable (though not necessarily the most likely) to me at the moment, but I certainly wouldn't rule out 50.

Much ink has been spilled and many pixels have been lit up over the 75 basis point move last week. Like you, I've been thinking a lot about it, but I have been reserving judgment. I have to admit that the timing of the move was a surprise. In the days leading up to the cut, I had been leaning towards a 50 to 75 basis point move at this week's meeting, but if I had been in the chair I would have wanted to avoid pulling the trigger right before a scheduled meeting. No doubt Mr. Bernanke would have wanted to avoid it too, if we were in a perfect world. So as an outside observer, I have to believe that Mr. Bernanke's main concern at that moment last week was the potential for a financial shock that would have immediate and long lasting impact on the real economy--a financial accelerator, to use the term that he used this summer. Real Time Economics also pointed this out at the end of last week.

So if the move last week was a calculated effort to cushion the financial markets to prevent such a shock, it may have worked, at least temporarily. The problem, and Mr. Bernanke no doubt knows this all too well, is that he spent a good bit of his ammunition on this one. The odds that there will be another in the near future are probably better than 2 to 1. I don't know many people who think that all the ugly surprises have been revealed. Even if the economy can technically avoid a recession (which it still may), we're still in for a bit of a bumpy ride. Another intermeeting cut in '08 is not out of the question.

And while I have tended to the hawkish side throughout the last couple of years, I agree with the general easing of monetary policy in recent weeks. It's a policy of containment. But I would also like to see rates go up more quickly (no more measured pace) when the current troubles have subsided.

I don't see last week's move as a case of "propping up" the market except to the extent that it may have bought the market some time to work things out. If you buy into the financial accelerator theory, that's not necessarily a bad thing. What remains to be seen is how well the Fed can transition back to a more balanced (i.e. more concerned about inflation) policy stance. I'm not 100% optimistic. I worry that the markets will get addicted to the rate cuts just as voters get addicted to fiscal stimulus. There's a Kydland and Prescott result lurking around here somewhere and I'm not sure it has a happy ending.

But this week, those concerns are pushed to the back burner, for better or for worse. While I agree with Gertler in the context of the near term concerns, I just wish that this policy stance didn't have the lasting ramifications that I fear it does. I hope that the Fed did not choose the lesser of two evils only to wind up with both. Only time will tell.

This is the largest rate cut in the modern era in which rate changes have been publicly announced. In fact, it's the largest cut going at least as far back as 1990. (UPDATE: This link says that it is the largest cut since October 1984.) Here is the full announcement. I'll be in class most of the day, but occasionally checking to see how the markets are doing.

The Federal Open Market Committee has decided to lower its target for the federal funds rate 75 basis points to 3-1/2 percent.

The Committee took this action in view of a weakening of the economic outlook and increasing downside risks to growth. While strains in short-term funding markets have eased somewhat, broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households. Moreover, incoming information indicates a deepening of the housing contraction as well as some softening in labor markets.

The Committee expects inflation to moderate in coming quarters, but it will be necessary to continue to monitor inflation developments carefully.

Appreciable downside risks to growth remain. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risks.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Charles L. Evans; Thomas M. Hoenig; Donald L. Kohn; Randall S. Kroszner; Eric S. Rosengren; and Kevin M. Warsh. Voting against was William Poole, who did not believe that current conditions justified policy action before the regularly scheduled meeting next week. Absent and not voting was Frederic S. Mishkin.

In a related action, the Board of Governors approved a 75-basis-point decrease in the discount rate to 4 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Chicago and Minneapolis.

A lot of it you know already, but some of it you probably don't. Go, read, and enjoy.

Hat tip to Marginal Revolution.

Hat tip to Greg Mankiw. The article is from the Telegraph (UK). Here's the opener:

As rebukes go in the close-knit world of central banking, few hurt as much as the scathing indictment of US Federal Reserve policy by Professor Anna Schwartz.

The high priestess of US monetarism - a revered figure at the Fed - says the central bank is itself the chief cause of the credit bubble, and now seems stunned as the consequences of its own actions engulf the financial system. "The new group at the Fed is not equal to the problem that faces it," she says, daring to utter a thought that fellow critics mostly utter sotto voce.

One thing is certain. The first sentence is right on the money.

Well folks, I am back in the saddle. It has been the semester break and so I've had a lot of other things to keep me busy. Not to mention the fact that for the past week I have been fighting a nasty cold/cough/sore throat and haven't felt much like doing anything except trying to heal up before the first day of class.

Plus, with politics on the brain there hasn't been a lot to get worked up about except the daily changing prospects for recession. That may change as the candidates propose various economic stimulus packages. I predict there will be much to say on that in the weeks ahead. As for the prospect for recession, it does seem that there are some parallels with the early presidential campaign of 2000 when everyone knew the economy was slowing, including the candidates, but the data wasn't showing it yet. It almost seemed as if all the talk about recession during the campaign made people even more concerned. Will that happen again and will the consequences be worse? Those are interesting questions that I think we might be addressing in 2008.

And China's inflation seems to be getting worse. Faster revaluation might be coming sooner than you thought. More on that later.

But of course, the item of immediate interest is mentioned in the Real Time Economics blog today:

Federal Reserve Chairman Ben Bernanke, responding to criticism that the central bank has sent confusing messages about interest rates in recent months, has decided to speak more forcefully and more often about the outlook for the nation’s economy.

The Fed’s new communications strategy comes after five months in which Wall Street analysts, academics and some former Fed officials have blasted the central bank for repeatedly implying it wouldn’t cut rates further, and then doing just that, and for sending other contradictory signals. Some Fed insiders shared those concerns.

Either Mr. Bernanke or Fed Vice Chairman Donald Kohn are likely to address the economic outlook in public at least once between policy meetings as long as the economic outlook remains unsettled. The idea is to help the market identify the Fed’s central view without relying solely on comments from lower-ranking members of the Federal Open Market Committee, the group of Fed governors and regional bank presidents that sets the target for short-term interest rates.

That would certainly be interesting. After thinking about this off and on for a while now, I've come to the conclusion that Mr. Bernanke's biggest mistake so far has not been underestimating how much the financial markets would depend on his comments, but underestimating how certain the markets would be about their interpretations. That's where the communication process seemed to break down. The analogy would be between the size of a coefficient and its standard error. It's as if sometimes the chairman's speeches were trotting out a coefficient for the markets and they ran with it only to find afterwards that the confidence interval was pretty wide. Presumably the more the chair (and vice-chair) speak to the markets the smaller the confidence interval becomes.

All through the autumn, my expectations had to remain pretty fluid. There were a lot of times when after reading the speeches and the data that I had to say that I couldn't predict with any certainty what might happen two or three weeks ahead. But the markets found that situation undesirable. Obviously they wanted more aggressive cuts. To an extent they may have helped prod the Fed in that direction. It was as if the market was saying, "We don't care about your uncertainty as long as your central tendency is leading you in this direction." Mr. Bernanke probably underestimated the trouble that would cause. I think that would be among the more easy mistakes to make, and one that has been made throughout history in other situations. A lot of the time you don't want to tip your hand to show what you don't know.

But central banking should probably take a more enlightened approach then clamming up. Instead, it may be beneficial to talk more frequently about what we do know, what has changed, and how to interpret the change. Now while I don't think that this new strategy will lead Mr. Bernanke or Mr. Kohn to talk in terms of percentages or odds. I do think it might be helpful if they would use the opportunity their new soap box will give them to talk specifically about how they interpret the latest data.

And while the last few months have been a little too exciting for the tastes of some market participants, I don't think this has been all bad. A time traveler from 1979 would look at the events of 2007 with awe concerning how well the markets aggregate information and expectations. It is a new and changing environment for central banks, and transparency clearly has some kinks to be worked out. Communication needs to be stronger about what we do know and perhaps dwell less on the uncertainty. I wouldn't argue with the proposition that the Fed needs to maintain an image of decisiveness--an image which it lost somewhat in 2007 through circumstances not entirely of their own fault. But I would take the current Fed/market relationship over the previous era where everything happened behind the curtain. Let's see how this new communication strategy works out.

Oh, and at the moment I'm torn between predicting 50 or 75 basis points for the next meeting. But I've got a gut feeling about which way the market is going to try to take it in the next few days.

Ok. I just applied the law of iterated expectations. I'm better now.